Is This Dividend Stock on the Value Menu?
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In the restaurant world, fast food chain McDonald's (NYSE: MCD) is the undisputed king. With over 34,000 locations in more than 100 countries McDonald's has one of the largest footprints in the industry, and over the past decade the company has achieved impressive growth. Not only that, the company has raised its dividend every year since 1976, a record matched by few other companies in any industry.
Because of this record McDonald's stock is held by many dividend growth investors, those who buy stocks that consistently grow the dividend over time. The stock is not currently part of my Ultimate Dividend Growth Portfolio, which aims to hold the best dividend growth stocks available, but should it be?
Looking at past dividend growth can give you a good idea of what the future holds, but you should never simply extrapolate the past into the future. Over the past decade McDonald's has grown its earnings per share at an annualized rate of about 18.7%, a truly astounding number. The dividend over the same period has grown at an annualized rate of 24.5%, significantly faster.
It should be clear that this situation can't continue forever. Eventually the payout ratio becomes saturated and the dividend grows only as fast as earnings grow. Over the last decade the payout ratio with respect to earnings has grown from 34% to 54%, leaving little room for further expansion. Companies like McDonald's typically keep the payout ratio under 60%, so I would expect dividend growth and earnings growth to converge fairly soon.
Another issue is that earnings growth is slowing. Over the past five years EPS has only grown by 9.3% annually, about half of the 10 year growth rate. Fiscal 2012 saw earnings growth of only 1.7%. Based solely on the past it's difficult to predict what future earnings and dividend growth rate to expect.
McDonald's has become so big that it's difficult to imagine the company growing anywhere near as quickly as it has in the past. International markets are the key to growing the store count, and new items like the McWrap are the key to maintaining same-store sales growth. But McDonald's is no longer the growth stock it once was. The average analyst estimate for annual earnings growth over the next five years is 8.6%, well below the historical value.
The stock has done basically nothing since the end of 2011, possibly because investors realized that the high-growth days of the past were likely over.
During this time of stagnation for the stock the dividend was increased by 10% to $0.77 per quarter, representing a yield based on today's price of 3.09%. Will the future dividend growth be high enough to justify paying nearly $100 per share for McDonald's stock?
Determining the fair value
A simple method for valuing a stock based on its dividends is the dividend discount model. This method values a stock as the sum of all future dividends discounted back to today by an appropriate discount rate. I like to use 8% as my discount rate for this type of calculation, roughly equal to the average annual return of the market over the long-term.
Determining the future dividend growth for McDonald's is tricky. The company has added healthy options to its menu over the years in an effort to compete with companies like Panera, and it's pushing its McCafe beverages as a cheaper alternative to Starbucks. This could very well drive same-store sales consistently higher, growth the company needs given the already enormous store count. Share buybacks should contribute a few percent to EPS growth each year, so a 9% growth rate seems reasonable. And there is still some room to grow the payout ratio, so the dividend growing by 9% for the foreseeable future doesn't seem far fetched.
Here's is the result of my calculation assuming that the dividend grows by 9% annually for the next 10 years using my dividend valuation tool:
McDonald's as a dividend stock is fairly valued at about $102 per share, just barely above the current market price. You'd be paying a fair price to buy McDonald's today.
Better restaurant dividends
While McDonald's is fairly valued there are two restaurant stocks I believe offer a better option for dividend growth investors. Darden Restaurants (NYSE: DRI) operates the Red Lobster, Olive Garden, and LongHorn Steakhouse restaurants along with a few others. What makes Darden stand out is a massive 3.9% dividend yield, far higher than that of McDonald's. Now, Darden doesn't have the economic moat or the margins that McDonald's maintains, but Darden has well known brands and has shown strong revenue growth. I suspect that Darden's dividend growth will be slower than McDonald's, but the far higher yield makes up for that and then some.
Another option is Yum! Brands (NYSE: YUM). Yum operates the Taco Bell, KFC, and Pizza Hut brands, and in terms of company revenue is about half the size of McDonald's. Yum has a low dividend yield of about 1.87%, but the dividend growth prospects are exceptional. Yum pays less than 40% of earnings out as dividends, and an active share buyback program will help to keep that number low. The most recent dividend increase was a solid 17.5%.
In the short term Yum is facing some problems. The company is very dependent on China, and the recent publicity surrounding the avian flu has caused KFC sales to seriously suffer in that country. In May same-store sales in China dropped by 19% company-wide. The good news is that this is a temporary situation, and sales should eventually recover.
The bottom line
McDonald's is fairly valued as a dividend stock, but there are better deals out there. While I won't be adding McDonald's to The Ultimate Dividend Growth Portfolio right now, I will add the stock to my Dividend Growth Watchlist with a buy target of $102 per share. McDonald's is a fine addition to a dividend portfolio, but it'd be even better at a lower price.
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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of Darden Restaurants and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!