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Market Update

McDonald’s Shares Look Undervalued but Patience Needed

McDonald’s investors must have a long-term horizon, as share price appreciation may be constrained until the company can deliver more consistent comp growth, says Morningstar’s R.J. Hottovy .

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 McDonald's (MCD) third-quarter results were a continuation of the past few quarters, weighed down by a challenging consumer spending picture and shrinking informal eating-out market. Even with a stronger product pipeline compared with a year ago and increased Dollar Menu emphasis, global comparable-sales growth of 0.9% represented the third consecutive quarter of deceleration on a two-year stacked basis. Management gave few reasons to expect an immediate reversal (calling for fourth-quarter global comps to be "in line with recent quarterly trends"), which will result in a modest reduction in our full-year revenue forecast (we now expect a little less than 2% top-line growth). The company also expects restaurant margins to decline "at a level relatively similar to first-quarter results," suggesting restaurant margin contraction of around 110 basis points to around 16.7%. The restaurant margin guidance (partly the result of higher protein costs) was below our estimates, but will be tempered by lower incentive compensation costs and keep our full-year operating margin forecast intact at around 31%. These changes effectively cancel each other out, and will keep our $105 fair value estimate unchanged.

Our wide moat rating remains intact based on a strong brand intangible asset, a cohesive franchisee system, and meaningful bargaining power and scale, and we believe McDonald's can eventually return to longer-term targets of 3%-5% systemwide sales growth, 6%-7% operating income growth, and return on incremental invested capital in the high-teens. While we believe shares are undervalued, we also believe investors must have a long-term horizon, as share price appreciation may be constrained until the company can deliver more consistent comp growth. McDonald's November Analyst Day will shed some light on upcoming menu and marketing innovations, but we believe comps may take several months to accelerate against aggressive industry promotional activity and limited price increases.

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R.J. Hottovy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.