McDonald’s (MCD) is a high-quality consumer staples stock. It has raised its dividend for 45 consecutive years and thus it is a Dividend Aristocrat. It is also a significant holding of Bridgewater Associates, the hedge fund of Ray Dalio, who is well-known for identifying stocks with superior risk-adjusted returns.

McDonald’s has greatly rewarded its long-term shareholders thanks to its exceptional growth record but the stock is richly valued right now. Therefore, investors should wait for a correction of the stock before purchasing it.

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Business overview

McDonald’s is the largest foodservice retailer in the world, with approximately 39,000 locations in over 100 countries and annual revenues of about $19 billion. Approximately 93% of the stores are independently owned and operated.

McDonald’s is facing a strong headwind due to the coronavirus crisis, which has caused a severe global recession and has resulted in the shutdown of many of the restaurants of the company for a considerable period.

In the full year 2020, the restaurant chain reported a 10% decrease in its revenues, which resulted primarily from the shutdown of its locations, particularly in Europe. Comparable sales edged up 0.4% in the U.S. thanks to strong average check growth but they declined 7.7% in total due to the pandemic-related restrictions in international markets. As a result, McDonald’s incurred a 23% decrease in its earnings per share.

On the one hand, this is the largest decrease in the earnings per share of McDonald’s in more than two decades. On the other hand, given the severity of the ongoing downturn, this performance is still satisfactory and reflects the resilience of the business model of McDonald’s.

Moreover, the pandemic is likely to subside at the second half of this year thanks to the massive vaccination program, which is underway all over the world. As a result, McDonald’s is likely to return to its long-term growth trajectory this year. Even better, as many small competitors have gone out of business due to the pandemic and McDonald’s has adjusted to the pandemic, McDonald’s is likely to emerge much stronger from the pandemic. We thus expect McDonald’s to achieve record earnings per share of $8.40 this year.

Growth Prospects

McDonald’s has consistently growing its earnings per share for decades. The company stumbled in 2012-2014 due to the increasing health consciousness of consumers, a somewhat obsolete menu, and intense competition from other fast-food chains.

However, McDonald’s managed to return to growth mode thanks to a series of initiatives, such as the offering of all-day breakfast and the enrichment of its menu with healthier options. Another major strategic move of McDonald’s was the franchising of its stores. That move resulted in lower revenues but much higher operating margins thanks to lower costs. The lean business model has greatly benefited the shareholders of McDonald’s in recent years.

Between 2008 and 2019, McDonald’s grew its earnings per share at a 7.1% average annual rate. As the company still has room to open new restaurants and grow the revenues of its existing restaurants, it is likely to continue growing its bottom line for many more years. We expect the restaurant chain to post all-time high earnings per share this year and hence we expect it to grow its earnings per share by approximately 6.0% per year over the next five years off this year’s somewhat high comparison base.

Dividend Analysis

Despite the pandemic, McDonald’s has raised its dividend by 3.2% this year. It has thus raised its dividend every single year since the initiation of its dividend, in 1976. McDonald’s has grown its dividend for 45 consecutive years and is a Dividend Aristocrat.

As McDonald’s is currently trading just 5% off its all-time highs, at a rich valuation level, the stock is offering a 2.4% dividend yield. This yield is much lower than the average historical yield of the stock and close to the 10-year low yield of 2.0%. On the other hand, given the healthy payout ratio of 61% of the stock and its promising growth prospects, investors can rest assured that McDonald’s will continue raising its dividend for many more years.

Valuation – Expected Return

McDonald’s is currently trading at a forward price-to-earnings ratio of 25.7, which is higher than the average price-to-earnings ratio of 21.0 of the stock over the last decade. In order to calculate the expected 5-year return of the stock with a margin of safety, we assume a fair price-to-earnings ratio of 19.0. If the stock of McDonald’s reaches our assumed fair valuation level over the next five years, it would incur a 5.9% annualized drag to its annual returns.

Given also the aforementioned 6.0% expected earnings-per-share growth and its 2.4% dividend yield, McDonald’s is likely to offer a ~2.5% average annual total return over the next five years. This expected return is not attractive, clearly reflecting that the stock is richly valued right now.

Final thoughts

McDonald’s is a high-quality Dividend Aristocrat, which should be on the radar of every income-oriented investor. The company has repeatedly proved that it is resilient to recessions and has greatly rewarded its long-term shareholders. Nevertheless, due to the current rich valuation of the stock, investors should wait for a correction before initiating a position.