Is McDonald’s Stock Now a Buy?

What a difference five months can make. Back in January, McDonald’s (NYSE: MCD) was trading at $102, thanks to 2011’s strong 34% rally, and more and more investors were excited to step into what looked like a well-established ride up. 

Looks can be deceiving… 

Not only did the rally not continue, but as of two weeks ago, shares of the world’s biggest restaurant chain have actually lost 11% of their January peak, with no apparent floor in sight. 

What happened to McDonald’s to merit such a reversal of fortune for shareholders? That’s just it — nothing really happened to the company. The stock simply took on a life of its own. 

#-ad_banner-#For investors who understand that a stock’s price can sometimes disconnect from the company’s actual performance, these wild swings can represent outstanding entry and exit opportunities. 

In fact, that window of opportunity is open right now. 

Though they may not know it, investors can collectively be quite intuitive. The gradual pullback that began in mid-January was due to no apparent reason at the time.

Then things started to make sense.

A couple of weeks ago, McDonald’s cautioned that the second quarter’s per-share earnings figure was going to be about 5%, or 7 to 9 cents, lower than first anticipated. Shortly after that, Goldman Sachs downgraded the company from “buy” to “neutral”.  

But regardless of weaker short-term quarterly results, McDonald’s is still a great stock own. Envisioning long-term performance is crucial for a stock like this.

In 2011, for instance, per-share earnings improved by 14% from 2010’s $4.61. And as previously noted, McDonald’s shares rallied 34% in 2011, sending them up to a price-to-earnings (P/E) ratio of 19.6 by the end of December. That’s a valuation that hadn’t been seen since 2007, and investors likely knew they were pushing their luck then, too.    

So where’s the stock valued now? At a trailing P/E of 16.8, which has been McDonald’s average P/E figure for the past three years. Translation: This is a fair price for the stock.

Proof that it’s an art and a science
The journey McDonald’s shareholders have been on during the past year and a half is a great reminder of two key lessons investors should embrace.

First, stocks don’t always reflect a reasonable value. McDonald’s was undervalued in 2009 when it was trading at less than 15 times earnings, and was overvalued in late 2011 when it was trading at 19 times earnings. Eventually, every stock is priced appropriately, so the market clearly knew enough to send McDonald’s shares lower from January’s highs

These market ebbs and flows are great times to buy or sell.

The second lesson is best summarized by Warren Buffett’s sage wisdom, “You can’t buy what’s popular and expect to do well.” 

McDonald’s was wildly popular in 2011, causing investors to pay too much for it. Sure enough, the bubble popped. It’s still an amazingly reliable company regardless of the share price, and it’s still poised to deliver a sixth straight year of earnings growth. The upside to the depressed price is a dividend yield of 3.1%. 

Yes, it’s true that Goldman Sachs thinks less of the company now. Just bear in mind that the rating didn’t budge until after investors suffered a 14% loss from the peak price. This means the return to a “buy” opinion may be just as tardy. Indeed, the stock may be a prime contrarian idea at this point. 

Risks to Consider: Some of the stock’s recent weakness has stemmed from nagging and growing worries about Europe’s economy. If the worst-case scenario comes to fruition there, then it could continue to apply pressure on McDonald’s shares, even if not deserved. 

Action to Take –> The bottom line is, McDonald’s is a “right company, right time” proposition. Though many would still argue the trailing P/E ratio is still frothy at 16.8, it’s not an unusual price tag for a blue chip as reliable as this one. 

From here, with shares technically poised to fight their way back to a premium valuation, the stock’s upside for the next 12 months is apt to be a little stronger than the forecasted annual earnings growth of 10%. For the same reason, the stock pulled back when it became too expensive early this year, and investors can’t be afraid to lock down the gain when it starts to trade at an earnings multiple of around 19 again, which would be a gain in the neighborhood of 15%.