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Why McDonald’s could deliver safe double-digit returns in 2014

Xun Yao Chen

Retirement picks: 4 restaurant stocks with dividends (Part 3 of 9)

(Continued from Part 2)

McDonald’s will likely be able to maintain its dividend growth

So can McDonald’s keep its dividend growth? Most likely, yes. Over the past few years, McDonald’s Corp. (MCD) has been aggressive with new store expansion plans in Europe and Asia, which are showing signs of recovery. While the labor market for young demographics (McDonald’s main target market) remains weak, the Federal Reserve (the central bank of the United States) will continue to support employment growth as long as inflation doesn’t skyrocket. It will just be a matter of time until McDonald’s benefits from higher consumer spending—especially since the stock has been moving sideways for a while.


The dividend discount model doesn’t work

The most common formula used to calculate the required return, or the share price, of a stock is the dividend discount model. But it doesn’t work for McDonald’s because the company’s earnings can’t grow at a rate of 10% every year forever. That would be like saying McDonald’s will become larger than the United States—currently growing less than 3% every year—and would be worth more than the US economy. While a two- or three-stage dividend discount model is also an option, who really knows when McDonald’s will stop growing? There’s much opportunity for the company to grow in Asia and Europe, and it may even be quite some time before the company’s earnings and dividend growth really do fall to mid-single digits.

McDonald could produce a safe ~14.5% return

To get around the problem, we can make simple assumptions. Any investment now in McDonald’s will generate 3.30% in return via dividends. When dividends rise by 11% or so (which is quite conservative because if employment does begin to pick up momentum across Europe, Asia, and the United States, it could be more), the market could be offering a price that’s 11% higher (or more) from the current rate. So, in total, McDonald’s could produce a return of ~14.5%. This will also benefit the Consumer Discretionary Consumer Service ETF (XLY), which invests in McDonald’s.

Why could the idea work?

This idea could work because in 2014, investors will be thinking the same thing. If dividends grow by ~10%+, then in 2015, they can sell at 10% higher. So as long as dividend growth continues at a high rate, share prices will also rise by a similar amount. Companies’ share prices often fluctuate sideways when earnings don’t grow as much, and they rally when earnings growth accelerates. When dividend growth begins to fall substantially, we’ll see lower returns—like how McDonald’s has pretty much moved sideways since 2012. Even if McDonald’s Corp. (MCD) isn’t seeing accelerated earnings growth next year, its probability increases over time. As Warren Buffett says, time favors good businesses. If McDonald’s does rise, so will the Consumer Discretionary Select Sector SPDR ETF (XLY).

Now let’s take a look at Yum! Brands Inc. (YUM) before moving on to Darden Restaurants Inc. (DRI) and Brinker International Inc. (EAT).

Continue to Part 4

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