We are strong believers in making buy, sell or hold investing decisions predicated on the fundamentals behind the business that the common stock represents.  On the other hand, we also acknowledge the undeniable reality that “Mr. Market” does not always price a company according to its intrinsic value based on earnings and cash flows.  However, we would further argue that “Mr. Market’s” shenanigans are more apt to apply over the shorter run than they are the over the longer run.  To summarize, earnings determine market price in the long run, but investor psychology can play havoc with sound fundamental values over shorter periods of time.

With this article we’re going to take an in-depth look at McDonalds Corp. (MCD) based on its fundamental value by the numbers.  There are two primary reasons for writing this particular article at this particular time, both of which were instigated by reader comments and suggestions.  First of all, we’ve seen a running debate regarding whether McDonalds (MCD) is fairly valued or overvalued at today’s valuation levels.  Second, we’ve been challenged to write articles that were depicting full value or overvaluation because we have typically only written articles on undervalued selections. We believe that because McDonalds had such a strong run in calendar year 2011, that many people believe that it now must be overvalued after rising so much.

McDonalds 2011 performance:  Low $72.14 – High $101.00

We believe that most investors are at a disadvantage because they typically are left with making their investment decisions based on price movement alone.  As we can see from the price only graph on McDonalds below, stock price rose very strongly throughout calendar year 2011, with only the month of September showing any negative movement (see red circle). Therefore, after an approximately 30% increase in value, many investors automatically assume that the company has become overvalued. On the other hand, as we will soon demonstrate, there is a difference between fairly valued, fully valued and overvalued.

Moreover, there can also be a significant difference between modestly overvalued versus dangerously overvalued. We believe these valuation distinctions are critical ones for investors to make.  Understanding these differences will have a significant impact on the risk return relationship.  As we will demonstrate, it is possible to buy a stock when it’s fully valued or even modestly overvalued and still be able to generate strong overall performance on your investment.  This point will be functionally related to the growth and more precisely, the rate of growth that the business behind the stock is capable of generating.

In other words, a company with powerful and/or explosive growth can overcome the investor mistake of paying a little more than fundamentals would suggest. We will attempt to show that when the investor does this, pay a little more than they should, they take on more risk for the eventual return they achieve.  However, if they do this with the right business, the rewards can still be handsome enough to compensate them for the extra risk.  Conversely, we will also attempt to clearly illustrate that a smarter purchase is made when valuation is fair, or even better, low. Furthermore, investing at or below fair value enhances future returns while simultaneously lowering risk.

McDonalds:  Fundamentally Speaking by the Numbers

Since McDonalds is one of the most widely-recognized brands on the entire planet, it hardly needs any introduction.  Therefore, we will refrain from any descriptive dissertation on the company or its business.  It’s most likely that most readers will have had a direct experience with McDonalds at one point or the other from visiting one of their restaurants. Instead, our objective will be to examine the fundamental relationship and correlation between McDonalds the business, and McDonalds the common stock.

In order to accomplish this, we are going to run McDonalds (MCD) through its paces utilizing the dynamic fundamentals analyzer software tool F.A.S.T. Graphs™. We’re going to examine McDonalds Corp. over various time frames from long to short in order to measure several important relationships and metrics.  First, we are going to evaluate McDonalds’ historical operating earnings history and determine whether the company’s earnings growth is accelerating or decelerating. In other words, has McDonalds’ recent earnings growth been better or worse than its past earnings growth?

Furthermore, we want to discover how “Mr. Market” has traditionally treated McDonalds’ business results by how it has traditionally priced their common stock. And very importantly, we want to evaluate how McDonalds’ current stock price measures up relative to the historical norm. But most importantly of all, we’re going to examine what the future holds for McDonalds’ shareholders given today’s current price and valuation.

McDonalds Corp.: A 20-year History of its Earnings Price Relationship

With our first graph we examine McDonalds’ earnings and price relationship since the beginning of calendar year 1993.  The orange line plots McDonalds’ earnings-per-share each year and applies a fair value PE of 15 to its above-average earnings growth rate of 11.5%. Then we correlate monthly closing stock prices (the black line) to the orange earnings justified valuation line which draws a picture of how the market has historically valued McDonalds’ shares relative to their earnings.  The dark blue line represents a calculated normal PE ratio which indicates that the market has traditionally priced McDonalds’ shares at a premium to their intrinsic value.

We have marked this graph with several arrows indicating variations in valuation.  For the time frame 1998 to 1999 we marked the graph with an arrow marked OV for overvaluation.  This is followed by an arrow marked UV for undervaluation for January 2003.  Then we offer two arrows marked FV for fully valued at October 2003 and the other at May 2007.  Then our final arrow marked IV for intrinsic value points to February 27, 2009 when McDonalds’ stock price was touching the orange line representing True Worth™ valuation.

What we are demonstrating with this exercise is how you can visually see that overvaluation resulted in poor short to intermediate term performance for long-term McDonalds’ shareholders.  However, even when McDonalds’ shares were significantly overvalued (1999), true long-term shareholders were still rewarded with capital appreciation if they still own the stock today.  However, they would have had to endure several years of losses before the stock price began to rise again. On the other hand, they would have received an increase in dividend income every year even during the times when stock prices were falling.

The graphic also illustrates that those investors with the presence of mind and courage to buy McDonalds’ stock once the price had fallen below the orange earnings justified valuation line were rewarded with excellent long-term returns, and thanks to low valuation, achieved them at below-average risk. Moreover, we can also see that investors that paid full value (the arrows marked FV) also achieved good returns over the long run. And finally, if McDonalds’ shares were bought at intrinsic value, long-term shareholder returns were strong.

The long-term (19-plus year) historical earnings and price correlated graph on McDonalds (MCD) teaches us an important and final lesson on valuation. Notice on the above graph that McDonalds’ stock price was touching the blue normal PE ratio line on the first day of the graph, and

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