Estimating The Intrinsic Value Of McDonald's Corporation (NYSE ...

Using the 2 Stage Free Cash Flow to Equity, McDonald's fair value estimate is US$233

Current share price of US$279 suggests McDonald's is potentially trading close to its fair value

The US$307 analyst price target for MCD is 32% more than our estimate of fair value

In this article we are going to estimate the intrinsic value of McDonald's Corporation (NYSE:MCD) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for McDonald's

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

("Est" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = US$71b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.2%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$13b× (1 + 2.2%) ÷ (8.2%– 2.2%) = US$216b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$216b÷ ( 1 + 8.2%)10= US$98b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$169b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$279, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at McDonald's as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.2%, which is based on a levered beta of 1.205. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Strength

Earnings growth over the past year exceeded the industry.

Debt is well covered by earnings and cashflows.

Dividends are covered by earnings and cash flows.

Weakness

Dividend is low compared to the top 25% of dividend payers in the Hospitality market.

Opportunity

Annual earnings are forecast to grow for the next 3 years.

Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

Total liabilities exceed total assets, which raises the risk of financial distress.

Annual earnings are forecast to grow slower than the American market.

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For McDonald's, there are three pertinent items you should consider:

Risks: Case in point, we've spotted 2 warning signs for McDonald's you should be aware of.

Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for MCD's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.