McDonald’s (MCD) is the largest publicly traded restaurant company in terms of market capitalization ($140 billion), way ahead of peers such as YUM! Brands (ticker: YUM) or Starbucks (ticker: SBUX).

McDonald’s has been a great investment in the past, as the company has produced consistent growth (earnings, share price, and dividends) for decades, easily outpacing the returns of most other restaurant companies. This is, at least partially, due to the fact that McDonald’s has very apt management, including CEO Steve Easterbrook.

Company Overview           

McDonald’s operates several thousand restaurants itself, on top of that the company franchises its restaurant concept to a multitude of franchisees all around the globe. McDonald’s was founded in 1940 and is headquartered in Oak Brook, Illinois. McDonald’s has raised its dividend annually for more than 25 years in a row, which makes the company one of the Dividend Aristocrats.

McDonald’s has reported its most recent quarterly results on October 23. The company generated revenues of $5.4 billion during Q3, its earnings-per-share totaled $2.10 during the quarter – an increase of 19% year over year. McDonald’s comparable restaurant sales rose by 4.2% year over year, vastly outpacing the growth of the restaurant industry.

Growth Prospects       

McDonald’s has a great growth track record. The company was able to more than double its earnings-per-share over the last decade, before that its growth rates were even stronger.

McDonald’s recent refranchising strategy has lowered the company’s overall revenues, but allowed for higher margins and improved the cash generation (due to lower capital expenditure requirements). Through the opening of new restaurants (franchised or company-owned), as well as due to rising comparable store sales, McDonald’s should be able to deliver mid-single-digit revenue growth in the long run.

McDonald’s has returned a lot of cash to its owners via share repurchases over the last couple of years, although some of these repurchases were financed via debt. The company will likely not do this forever, as rising interest rates could make high debt levels problematic. The company will continue to repurchase shares, though (dividends and stock buybacks should be relatively in line with free cash flows going forward). Through some share repurchases and the impact of rising revenues McDonald’s should be able to produce earnings-per-share growth of at least ~6% annually going forward.

Valuation, Dividends, And Expected Returns

McDonald’s shares are trading at $183 right now, which is just a couple of percentage points shy of the all-time high at $190. Relative to our forecast for earnings-per-share of $7.60 during the current fiscal year McDonald’s is thus valued at 24 times earnings right now.

McDonald’s is a high-quality restaurant company with a strong track record, but this valuation is too high, we believe. McDonald’s shares were valued around 20 times annual profits throughout most of the last decade, which means that shares could be overvalued by 20% right here. If McDonald’s multiple declines to 20 over the next five years, this would represent a 3.5% annual headwind.

McDonald’s dividend yields 2.5% right now, which is more than the broad market’s yield, but which is less than McDonald’s yield during the last couple of years (usually around 3%).

Through a combination of earnings-per-share growth of 6% and a dividend yield of 2.5%, offset by a 3.5% valuation compression headwind, McDonald’s could produce annual returns of 5% a year going forward.

Final Thoughts

In terms of scale and quality, McDonald’s is one of the best restaurant companies in the world. The company has produced compelling total returns in the past, but right here shares are looking too expensive. It is likely that investors will only get mid-single-digits total returns over the coming years when they buy shares right here, which is why we believe that McDonald’s is only a hold right here.