McDonald's Corporation - Corporate Finance 'Takeaways'

Date: Dec 28, 2020

Corporate background

McDonald’s operates and franchises close to 40,000 quick service restaurants (approx. 93% franchised) serving fast-food items in over 100 countries. Incorporated in the U.S. with over six decades of operating history, McDonald’s had a massive employee base of over 200,000 and generated revenues of $21 Bn in 2019.

The company’s revenues consist of sales by self-operated restaurants and fees (rentals and royalties) from franchised restaurants. The franchise model is based upon either of the following structures:

• Conventional franchise – McDonald’s, generally owns or secures a long-term lease on the land and building for restaurant location and franchisee pays for equipment, signs, seating, décor along with reinvesting capital in business over time
• Developmental license or affiliate – McDonald’s, normally does not invest any capital under a developmental license or affiliate arrangement, and it receives a royalty based on a percent of sales, and usually receives initial fees upon the opening of a new restaurant or grant of a new license

1 Corporate governance

1.1 Stockholder analysis: Who has the control?

The company has significant institutional ownership of about 68% (in June 2020) followed by close to 32% of public ownership with over less than 1% being held by insiders, public corporations (Cowen, Inc. and Equitable Holdings, Inc.) and State (North Carolina Department of State Treasurer). Top five institutional stockholders own about 27% (see table below) of the company which indicates that the marginal investor in McDonald’s is well diversified and does possess reasonable control over the functioning of the company. Therefore, it is safe to assume that only risk to be counted into the discount rate is market risk (non-diversifiable) estimated with beta or betas.

1.2 Board of directors: Whose interest does the Board serves?

McDonald’s has a significant board size with 13 members including the current CEO, Chris Kempczinski as one of the directors. The Chairmanship resides with Enrique Hernandez, Jr. who is a board member since last 24 years. In fact, close to 50% of the board members have 11-24 years of board membership in McDonald’s which might be older than incumbent management. Also, close to 30% of the board members have other directorships with 8-10 companies which is high enough to manage judiciously. Though the board is largely independent, the members lack relevant experience and only 2-3 members have some experience in food, restaurant and real estate (helpful for leasing/franchise rentals) businesses.

As mentioned earlier, the top five shareholders though institutional and passive, hold around 27% of the entire corporate ownership. Along with them, there are few activist stockholders (including D. E. Shaw, Taconic Capital Advisors, Royal London Asset Management Limited, etc.) however, the current ownership is insignificant. But there could be an inherent risk of share transfer from the institutional to the activist cohort if board turns sloppy to safeguard stockholders’ interest. Also, the largely independent board would likely to challenge the incumbent management, if warranted, given low insider-ship.

Recommendations:

• Reduce the size of the board from 13 to 7-8 members to facilitate quick and effective decisioning given McDonald’s is a mature company
• Try to retire the legacy members and bring in new faces with adequate relevant industry experience and with experience to supervise a mature entity
• Keep a cap on the number of other directorships a board member represents to minimize distraction and maximize effectiveness

2 Risk and return profile

2.1 Regression approach to risk and return assessment

Regressing historical stock returns against market returns to estimate how McDonald’s performed in terms of returns generated during past five years.

Regression Beta

I regressed McDonald’s monthly returns for the last five years against total returns during the same period for NYSE Composite Index to arrive at the equation:

Rj = 0.0109 + 0.6222 Rm

The slope of the line of best fit with 59 data points stands at 0.6222 which is known as the beta, the relative measure of risk. It indicates if market (NYSE Composite) moves by 10% McDonald’s will move by around 6.2%. However, the resultant beta is quite unreliable given the standard error of 0.1279 suggesting that beta could be anything between 0.4943-0.7501 and 0.3663-0.8780 at 67% and 95% confidence interval, respectively.

Also, the R2 from the regression stands at 29% indicating that only 29% of the movement in McDonald’s stock is explained by the market. In other words, only 29% of the overall risk is market risk and the balancing (71%) is firm specific risk (diversifiable). 

The other half of the regression equation indicates an intercept of 1.09%. Subtracting Rf(1-Beta) from the intercept to get Jensen’s Alpha of 1.05% (i.e. 13.36% on annualized basis). It means that McDonald’s had delivered annual returns of 13.36% over and above the expected returns during the last five years. Please note the company had been running a significant buyback program since last couple of years which is not included in calculation of returns. The implicit assumption being the buyback return on McDonald’s offsets buybacks in the market as the index is dividend adjusted but not buyback adjusted (not a firm assumption though!). Finally, putting the historical inputs into the CAPM suggests an annual expected return of 4.19% for McDonald’s.

2.2 Fundamental assessment of risk and return profile

Given the wide range of beta due to high standard error in regression process and backward-looking historical data, clearly raise concerns on the reliability of expected return for McDonald’s, therefore, considering a forward looking approach to estimate a futuristic cost of capital or a hurdle rate for the company.

Bottom-up beta

I screened for global restaurants self-operating, franchising and licensing quick service restaurants and considered the median of their last five-year beta from S&P Capital IQ. Median beta (0.9630) is then unlevered (0.6167) using their median debt/equity ratio and median tax rate basis the Hamada equation [BetaL = BetaUL {1 + (1 – t) (D/E)}]. The unlevered company beta is then correct for cash to arrive at business unlevered beta at 0.6821. Finally, the market value-based debt to equity ratio and marginal tax rate for McDonald’s were utilized to arrive at levered beta for the company at 0.8443.

Cost of equity

The Capital Asset pricing Model (CAPM) is applied to estimate cost of equity for the company, Ke = Rf + Beta x (ERP(mature market) + CRP). Let us look at each of the inputs and assumptions below:

• Risk-free rate (Rf): As the entire analysis is done in the U.S. currency, I considered 10-year T-Bond rate in the U.S. as the risk-free rate = 0.86% (source: treasury.gov)
• Beta: Bottom-up levered beta estimated at 0.8443
• Equity risk premium [ERP(mature market)]: Implied equity risk premium for the U.S. market for Nov 2020 = 5.35% (source: https://pages.stern.nyu.edu/~adamodar/)
• Country risk premium (CRP): McDonald’s is a global company with a revenue split of 37%(U.S.):63% (rest of the world). Given, no explicit break-up of overseas revenues, a global CRP of 1.5% is considered to estimate an additional risk premium of 0.96% (i.e. 1.53% x 63%).
• Cost of equity (Ke): With all the inputs into the CAPM results into a cost of equity of 6.19% 

Cost of debt

On Dec 31, 2019, the company had interest-bearing debt ($34.2 Bn) and debt equivalent of operating leases ($13.4 Bn) at $47.6 Bn at book-implied pre-tax interest rate of 2.4% (a blend of short-term and long-term interest rates). However, yield on a long-term traded bond with maturity in 2037 was 2.67% in Nov which has been considered as long-term pre-tax cost of borrowing for the company. 

Build-up approach is also considered to estimate (sense check) the pre-tax long-term interest rate for the company, Kd = Rf + corporate default spread. Let us look at each of the inputs and assumptions below:

• Risk-free rate (Rf): Consistent with cost of equity approach, I have considered 10-year T-Bond rate in the U.S. as the risk-free rate = 0.86% (source: treasury.gov)
• Corporate default spread: Moody’s and S&P rated the company’s long-term credit risk at Baa1 and BBB+, respectively. Basis the current long-term credit rating of McDonald’s, a default risk of 1.81% corresponding to BBB rating has been considered from updated credit rating table (Jan 2020 is available in public source however, July 2020 spreads were considered)
• Cost of debt (Kd): With all the inputs in above equation yields an estimate of the long-term pre-tax borrowing rate for the company at 2.67% and post-tax interest rate at 2.00% (marginal tax rate being 25%)

The long-term pre-tax interest rate on borrowing estimated from synthetic rating approach (2.67%) is close to the yield on the long-term traded bond (2.84%) of McDonald’s. The latter has been considered in calculation of WACC.

Cost of capital

Cost of capital or hurdle rate is given by the weighted average of cost of equity and post-tax cost of debt with weights being market values of equity and debt, Kc = {We x Ke} + {Wd x Kd (1 – t)}. Weight of equity (We) reflects the market capitalization (as on Nov 3rd) divided by the firm value (market value of equity and debt). Weight of debt (Wd) reflects the market value of debt including leases divided by the firm value. Market value of interest-bearing debt is estimated by treating all the existing debt as a giant bond with existing finance cost as annual coupons. Then market value of debt is computed by summing up present values of those expected annual coupon outflows throughout the weighted average maturity period of all existing debt and present value of bullet payment of the overall debt amount at pre-tax interest rate of debt (2.0%).

Operating leases are also capitalized at pre-tax cost of debt. Average lease payment for initial set of years was utilized to estimate the annual lease payment beyond fourth year through 12 (approx.) years.

Putting all the standard inputs into the above equation to arrive at a hurdle of 5.21% for McDonald’s. It means that McDonald’s should accept upcoming projects if and only if it generates at least 5.21% returns for the company.

3 Investment analysis: Does McDonald’s generates excess returns?

McDonald’s witnessed an average sequential decline of 5% in revenues since last six years and this trend is akin to close peers (including The Wendy’s Company, Wingstop and Yum! Brands) who registered an average annual decline of 7% (approx.) during similar period. However, the company franchised some of its self-operated restaurants (higher fixed cost) and improved operating margins by an impressive 13% (from 29% in 2014 to 42.2% in 2019) during the last six-year period despite declining topline. The margin improvement was primarily the result of franchising which is a higher margin and predictable cash flow business. In 2019, the company had a topline of $21 Bn and operating margin of 42.2%.

Return on invested capital (ROC) stood at 18.5% and 14.8% for 2019 and last ten-year average, respectively. The returns are quite impressive compared to the overall cost of capital at 5.2% (food processing is a relatively safe business). It means that the company registered excess returns to the tune of 13.3% in 2019 and an average of 9.6% during last decade if one assumes a constant hurdle rate over the said period. Therefore, in 2019, the excess returns resulted into an economic value added [return spread x BV of invested capital(t-1)] of $4.8 Bn.

Investment outlook

Declining revenues since last few years are concerning and the company intends to get back to growth track by customer retention and acquisition initiatives. McDonald’s is working on couple of initiatives to enhance the customer experience by embracing novel technologies and very recently, planning to broaden the food menu by introducing healthy food options. Strategic initiatives cited in annual filings for 2019 and media are stated below:

• The Velocity Growth Plan: The strategy is focused on enhancing customer experience through improved restaurant execution with technology at the core to enable greater convenience and customer personalization. The objectives of the plan are retaining existing customers, regaining customers who visit less often and converting casual to committed customers
• Growth accelerators: To scale and optimize the Plan, the company is focusing on three growth accelerators – experience of the future (restaurant modernization to enhance the brand and service experience), digital (leverage technology enabling greater convenience such as global mobile app, self-order kiosks, etc.) and delivery (add third-party delivery partners to maximize delivery scale and potential)
• McPlant: McDonald’s partners with Beyond Meat to debut its line of plant-based meat alternatives from 2021; a foray into healthy food products to expand customer base. Though the stock price dropped by 8% on initial announcement but later regained 4% on the announcement of Beyond Meat’s role in co-creating the patty

I feel the high revenue growth days for McDonald’s are far behind and it is showing traits of a typical mature company. Though the decline in revenues were shadowed by shift in operating model towards higher margin franchising business compared to high cost self-operated restaurants. This helped the company to significantly improve profitability margins amid falling revenues. Also, the annual increment in dividends and heavy buybacks added to stockholders’ delight. I think the operating margin is near its peak given 93% restaurants are already franchised. Moreover, franchise-based model has a flipside of lesser control over the restaurants which resulted into several instances of slippages in maintaining food hygiene (Asia, China and Japan) leading to closure and brand dilution. Also, stiff competition in the industry (over 50 known brands compete in the U.S.) is expected to limit future revenue growth and put pressure on margins. Rapidly changing consumer taste and preferences towards healthier and nutritive food could further restrict the growth in the fast food industry.

I think the growth initiatives which are towards enhancing customer convenience and experience are supportive but the primary driver in this industry is affordable, good quality and tasty food. If the company is able to pull-off its new growth strategy and new food offerings add to customers’ delight, then it could witness a decent growth phase for a couple of years.

Recommendations:

• Besides the Velocity Growth Plan in implementation phase, I would suggest the company to explore other food offerings but under different branding to safeguard McDonald’s brand image in case things go south. It is very difficult to create a taste which has a mass appeal! Case in point – Nestle had to reintroduce old Maggi Masala (with tagline – your old Maggi Masala is back in Indian markets) after receiving poor customer response to many newer versions of Maggi 
• Careful selection of franchise partners with more stringent clauses to avoid brand dilution due to non-adherence of standard and healthy operating procedures
• Foray into new food offerings could be risker compared conventional business hence, appropriate cost of capital to be utilized to compute the hurdle rate

4 Capital structure: What are McDonald’s financing choices?

McDonald’s utilizes a D/E mix of 75:25 to finance its existing asset base in market value terms. Out of total $52 Bn of debt, 71% ($37 Bn) is traditional debt while balancing 29% ($15 Bn) is lease debt. The interest-bearing debt is largely long-term debt with average maturity of 20 years which matches the duration of a typical franchise term. Also, the existing debt is a blend of regional and foreign currency denominated issuances as McDonald’s has global operations. However, I would recommend reversing the proportion between domestic and foreign borrowings given overseas revenues at ~62% of overall topline. I believe that McDonald’s has some pricing power (though constrained given stiff competition in affordable food industry) at least in self-operated business (45% of revenues) hence, proportion of floating rate debt could be increased to 45%. The rest of the business constitutes rental income (mostly fixed and contractual) and royalties, therefore, 55% of debt could be in form of fixed rate debt.

  What are the benefits and costs associated with debt?

• Tax benefit: The company’s effective tax range is 23% – 25% while the global average tax rate (marginal) is around 25% which suggests reasonable tax savings on interest payments.
• Added discipline: Less than one percent of insider stake in the company suggests that debt could be looked upon as a disciplinary mechanism for McDonald’s incumbent management.
• Expected bankruptcy cost: McDonald’s has a stable and impressive operating history. The company’s operations seem to be immune from any global shocks evident from mere 0.6% of volatility in operating income in last 30 years. The major drop in operating earnings was just 8.4% in 2001, after the collapse of the dot.com bubble. Hence, I would assess the expected bankruptcy costs for McDonald’s to be quite low with high debt appetite given stable and relatively immune business operations.
• Agency cost: The credit rating agencies (S&P’s and Moody’s) representing the lender community have assigned a long-term credit rating of BBB+ and Baa1 to McDonald’s, respectively. Ratings were based upon the current operating challenges and expectation around weakening of earnings and credit metrics. The entire restaurant industry is facing challenges across globe in terms of restricted operating environments recommended by respective governments in order to contain the pandemic. Rating agencies expect McDonald’s to strengthen its credit metrics (once the economy and business situation recovers) through improved earnings, debt reduction and pause on stock buyback programs.    
• Loss of flexibility: The historical performance and current fundamentals (high interest coverage ratio) do not suggest any significant loss of flexibility in terms of debt affordability; however, overfriendly dividend and buyback policy do put potential constraints on capital raising via debt route.

I think McDonald’s does benefits from having debt into its capital structure but has high agency cost in terms of convents including cross-acceleration provisions and restrictions on mortgages. Moreover, continued usage of debt to cover stock buybacks have caught unwanted attention of the rating agencies which now expect the company to start paying-off some debt and halt buybacks. I would recommend McDonald’s to limit further borrowing as it could lead to rating downgrade and higher cost of debt instead utilize its free cash flows to start paying off some debt.

5 Financing mix: What is the optimal debt ratio for McDonald’s?

McDonald’s synthetic rating is AAA based upon interest coverage ratio in 2019 whereas its actual rating is BBB+. The difference can be attributed to the COVID setback to the restaurant industry (at least in the near term), other ratios and qualitative factors (continued usage of debt to cover stock buybacks).

From peer benchmarking perspective, McDonald’s seemed to be slightly under-levered at debt ratio being 24% against peer median debt ratio at 28% in market value terms. Similarly, net debt to capital ratio for McDonald’s stands at 22% compared to peer median at 25% in market value terms.

I leveraged the cost of capital approach to assess the optimal debt mix for McDonald’s basis synthetic rating table. Debt ratio at 30% seems optimal for McDonald’s given its interest coverage ratio in 2019. The company has debt ratio of 24% with $52 Bn in market value of debt hence, there is room to borrow additional $12 Bn to reach the optimal capital mix and minimize WACC at 4.95%.

However, McDonald’s is constrained at a lower rating (BBB+) which corresponds to an interest rate of 2.67%. Therefore, I adjusted the pre-tax interest rates in the look-up table by the delta between actual spread and spread at AAA (synthetic rating basis interest coverage ratio) to re-estimate optimal capital mix. With the adjusted interest rate approach, the optimal capital debt ratio for McDonald’s is 0%. This is primarily due to low delta between post-tax cost of debt and equity. The rise in cost of equity due to higher levered beta offsets tax and lower-cost benefits associated with debt such that WACC rises by the introduction of debt into capital mix. Given the nature of business, wherein restaurants are required to be taken on leases, a certain level of debt is required in business. Around 30% of overall debt in the company takes the form of lease debt (i.e. $15 Bn). Remaining debt of $37 Bn has been matched with cash inflows from minimum rent under franchise agreements (refer to contractual cash flow table below) can be paid-off gradually such that only lease debt is targeted to cover for current and future needs.

Recommendations:

• McDonald’s is a mature company with revenues declining since last couple of years but has strong cash inflows to support its investment requirements
• Refrain from using debt to cover stock buybacks ($28 Bn net-debt raised in last 10-years to cover buybacks)
• Restrict debt levels to cover for current and future operating leases which would be achieved at 10% debt ratio with debt being $20 Bn
• Gradually pay-off non-lease debt from internal accruals after meeting investment and dividend requirements   

6 Dividends and Buybacks: How does McDonald’s return cash to its stockholders?

McDonald’s follows an annual incremental dividend policy and has history of paying dividends over past 45 consecutive years. Observations basis LTM and past ten-year dividend and buyback payments are highlighted below:

• High dividend payout ratio (DPOR) at 76% (LTM) and 61% (10-year average) suggests corporate maturity but slightly lower than peer average at 80% (LTM) and 100% (10-year average)
• Healthy dividend yield at 2.3% (LTM) and 2.8% (5-year average); a notch below peer average numbers at 2.6% and 2.9%, respectively
• Dividend per share (DPS) grew by 5.7% last year and registered CAGR of 8.3% over last ten years supporting an aggressive incremental dividend policy
• Pre-debt FCFE sufficed over last decade to cover up the dividend payouts with dividend/FCFE (pre-debt) at 87% (LTM) and 64% (10-year average)
• Overall, cash returned including buybacks stood close to 1.5x of pre-debt FCFE suggesting debt issuances to cover for buybacks
• Last ten-year average numbers indicate that McDonald’s returned almost 100% FCFE to its stockholders but at the expense of debtholders

7 Dividend assessment: What should be the cash return policy for McDonald’s?

DPOR (higher than global average) seems to closely follow the peer set. This suggests compulsive peer followership wherein everyone is competing to impress the stockholders in order to maximize shareholders’ wealth. There is no harm in paying higher dividends, but dividend policy should sync with free cash flows (pre-debt) available with the company. Moreover, leveraging debt issuances for longer periods to cover heavy buyback programs could be dangerous and signs are already visible in Moody’s rating action (Mar 2020) on a senior unsecured note with expectations from McDonald’s to improve credit metrics, reduce debt and hold on to share buybacks. S&P cited a similar note and ruled out upward rating revision (even if operating metrics are supportive) given McDonald’s focus on high cash return policy towards its stockholders. In fact, S&P warned the company to downgrade if the buyback momentum continues beyond current plans.

Recommendations:

• I think the company pursues an aggressive dividend policy (i.e. annual incremental dividend) which could turn risky as the firm continues to mature. Current cashflows have been enough to cover for the annual increments (87% of pre-debt FCFE) but it cannot be true forever. Hence, I would advise McDonald’s to switch to a residual dividend policy to break the incremental pattern sooner rather than later
• The change in dividend policy announcement would not come easy given current investor clientele (mainly institutions) and cash return history but residual policy for a company such as McDonald’s could be rewarding as well (higher than current dividend payouts in good years)
• A pause on buybacks could be announced in the light of restricted business environment due to the pandemic outbreak however, it could be supported by investment into new food offerings and debt repayment which could lead to a better hurdle rate and the maximize value of the business; so, capital appreciation lieu of buybacks; the announcement could be further supported by a more friendly dividend policy tied to available free cash flows
• There could be initial turbulence in stock price post-announcement, but the investors might eventually come to terms McDonald’s viewpoint given high Jensen’s Alpha generated over last five-years and huge excess returns over cost of capital

8 Valuation: What is the value of McDonald’s?

Intrinsic valuation I: DCF approach to assess the intrinsic status-quo value of McDonald’s basis following assumptions:

• Explicit forecast period: Expected growth in FCFF is a product of recent reinvestment rate (LTM Sep 2020) and (optimistic) return on incremental invested capital. Average ROC during last ten years was 14.8% while one-year and three-year returns on incremental invested capital were 22.8% and 40.6%, respectively (refer annual report for 2019). Also, McDonald’s expects the ROC to be in mid-20’s going forward hence, 25% is my optimistic assumption for ROC for next five years basis continued conversion towards higher margin franchise business and successful Velocity Growth Plan. The growth is expected to decline linearly to converge with risk-free rate (proxy for stable growth) during next five years
• Stable growth period: ROC is expected at 10% which still exceeds WACC at 5.43% basis relatively higher competitive advantages due to superior brand positioning. The implied reinvestment rate to support the stable growth would be 8.6%
• WACC: I have assumed constant cost of capital for McDonald’s at 5.26% with 24% debt ratio and levered beta at 0.8443 as food business is expected to remain a safe business
• Value: Running the numbers through the model resulted into an equity value for common shareholders at of $115.6 Bn after deducting value of options at $1.6 Bn from equity value of $117.2 Bn. Dividing equity value for common shareholders by number of outstanding common shares results into value per share at $155, approx. 27% below the then market price of $213 per share
• Sense check: Terminal year NOPLAT ($9.3 Bn) is based upon operating income of $12.5 Bn. If we assume stable period EBIT margin at 25% (management guidance) then stable period revenues would be $27.7 Bn. Given the LTM (Sep 2020) revenues at $21.1 Bn, I am implicitly assuming a CAGR 2.8% over next ten years which seems a reasonable growth number
• Deduction: Even the optimistic cash flow estimates (assumed every investment and growth plan to be super successful) suggest that McDonald’s is overvalued by the market. I think the rationale for overpricing is the impressive operating performance (increasing operating margins from 30.3% in 2010 to 42.2% in 2019) amidst muted revenue growth during same period and, massive return of cash to the shareholders ($77.3 Bn) in last ten years

 Intrinsic valuation II: Basis investment and financial analysis, I incorporated two major changes (higher reinvestment rate and lower WACC) into the DCF model to assess potential increase in business and equity value:

• Explicit forecast period: I have increased the reinvestment rate for the explicit forecast period from 27.7% (current) to 35% based upon my assumption for the company to find adequate investment opportunities in terms of new franchise business and broadening of food options (McPlant). Higher reinvestment rate coupled with a high ROC of 25% would result into a higher growth rate at 8.75% for next five years. 
• Stable growth period: Still expect ROC to stabilize at 10% but higher cash flows (due to base effect) and a lower WACC led to a higher terminal value.
• WACC: I have assumed McDonald’s to pay-off its non-lease debt (piled-up over time primarily to cover stock buybacks) from internal accruals over next ten years to move towards and optimal capital mix and also, lock in a lower interest rate due to improvement in ratings with debt repayments. Consequently, WACC is assumed to linearly decline from 5.26% to 5.09% during the ten-year forecasted period.
• Value: Running the revised numbers through the model resulted into an equity value for common shareholders at of $167.2 Bn after deducting value of options at $1.6 Bn from equity value of $168.8 Bn. Dividing equity value for common shareholders by number of outstanding common shares results into value per share at $224, slightly more than the prevailing market price of $213 per share.
• Sense check: Terminal year NOPLAT ($10.5 Bn) is based upon operating income of $14.0 Bn. If we assume stable period EBIT margin at 25% (management guidance) then stable period revenues would be $31.2 Bn. Given the LTM (Sep 2020) revenues at $21.1 Bn, I am implicitly assuming a CAGR 4.0% over next ten years which is higher given the size of McDonald’s but still plausible given the size of fast food industry. According to Research and Markets, the global fast food market size was valued at $647.7 Bn in 2019 and is estimated to reach $931.7 Bn by 2027, growing at a CAGR of 4.6% during the forecast period. If I extrapolate with 4.6% industry growth to continue for next four years, then market size would be $111.7 Bn in 2031 (i.e. when McDonald’s hits stable phase). Basis the global market size in 2019, McDonald’s had a market share of 3.3% which would be around 2.8% in terminal year basis my growth assumptions for McDonald’s and extrapolated global market size. A revenue growth for McDonald’s below global industry growth and slightly reduced market share due to stiff competition suggests my assumptions pass the reasonability check for the stable phase.   
• Deduction: The best-case cash flow estimates (higher reinvestment opportunities at mature stage and successful reception of new food offerings by customers) coupled with lower cost of capital help converge the value-price gap for McDonald’s. However, this would not be easy for McDonald’s to pull-off given its size and state of the industry (over 100 of global and regional brands) but if it can, it will generate (higher cash flows) and unlock (lower discount rate) potential business value of $22.2 Bn and equity value of $51.6 Bn from status-quo valuation numbers.

Summary

• McDonald’s is the largest and well-established global fast food company with strong brand equity and a safe investment for shareholders
• McDonald’s has a good corporate governance mechanism with largely independent board, however, should review on board size, relevant experience and other board commitments of current members
• McDonald’s has been quite successful at sustaining competitive advantages evident from generating higher excess returns over its cost of capital
• McDonald’s WACC rises with introduction of debt into the capital mix due to cost of equity being over-sensitive to debt inclusion. Given, internal accruals are sufficient to cover investment needs and dividend payments, it is suggested to use remaining cash to reduce its non-lease debt and perhaps, improve credit rating as a by-product to reduce overall WACC and maximize firm value
• McDonald’s has an aggressive dividend policy with high payout ratio. Moreover, it leverages debt to carry out its stock buyback program which has been pointed out by credit rating agencies in their respective credit report summaries and could result into potential rating downgrade, if continued, hence, a residual dividend policy is suggested for the company
• McDonald’s seems to be overvalued by the market at $213 per share as the intrinsic value per share stands at $155 basis current expectations built into the DCF valuation model. However, if the firm follows a higher reinvestment regime (if opportunity exists along with higher ROC) and locks in a lower discount rate (move towards optimal capital mix), the intrinsic value per share converges with the market price           

Disclaimer: The views expressed are personal with NO intention to provide buy or sell recommendations.