McDonald’s Corp. (MCD) stock has recently faced headwinds, tumbling amidst investor apprehension regarding the impact of elevated gas prices on consumer spending and, consequently, restaurant sales. However, this market reaction may have been overstated, particularly as gas prices begin to recede from their peaks. This analysis delves into MCD’s underlying valuation, drawing on free cash flow metrics, and explores sophisticated options strategies designed to capitalize on potential upside.
MCD closed at $269.76 on Friday, June 26, marking a recovery from a recent low of $264.54 on June 25. Despite this rebound, the current price remains significantly below its 3-month high of $311.36, recorded on April 17. This decline presents a potential entry point for astute investors.
Revisiting MCD’s Valuation: The Free Cash Flow Perspective
Our previous analysis, detailed in a May 10 Barchart article titled “McDonald’s Stock Falls Through 1-Year Lows – Are Sales Slowdown Fears Overdone?“, highlighted McDonald’s robust free cash flow (FCF) generation. FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It is a critical indicator of a company’s financial health and its ability to pay dividends, repurchase shares, or reduce debt.
Based on projected revenue and a consistent FCF margin, MCD could still be valued considerably higher. Analysts forecast McDonald’s revenue to range between $28.5 billion this year and $30.17 billion next year. This translates to an estimated $29.335 billion in Next Twelve Months (NTM) revenue. Applying McDonald’s average trailing 12-month FCF margin of 26% to this NTM revenue projection indicates a potential annual FCF generation of $7.63 billion.
To determine a fair market value (FMV), we utilize an FCF yield of 3.6%. FCF yield (FCF per share / share price) offers an inverse perspective to the P/E ratio, indicating the cash return generated by the company for each dollar of its market capitalization. Using this yield, the intrinsic FMV for McDonald’s is calculated as follows:
- $7.63 billion FCF / 0.0359 = $212.5 billion FMV
This calculated FMV of $212.5 billion is 10.6% higher than McDonald’s reported market capitalization of $191.7 billion as of Friday, June 26, according to Yahoo! Finance. This disparity suggests a considerable upside. Translating this into a price target (PT):
- ($212.5 billion / $191.7 billion) = 1.109
- $269.76 (current price) x 1.109 = $299.16 PT
Other financial analysts concur, with several publishing even more bullish price targets. For instance, Yahoo! Finance’s average analyst survey indicates a PT of $330.94, Barchart’s suggests $330.59, and AnaChart’s is $351.90. However, it is crucial to remember that these are projections and market conditions can always introduce volatility. No investment is guaranteed to reach its target price.
Strategic Approaches to Play MCD Stock
Given the potential for undervaluation, investors can employ options strategies to manage risk and enhance returns. One method involves selling out-of-the-money (OTM) puts, while another includes purchasing in-the-money (ITM) calls, potentially in combination.
Selling Out-of-the-Money Puts for Income
Selling OTM puts allows an investor to generate immediate income (premium) while agreeing to potentially buy the stock at a lower, predetermined price (strike price). For example, consider the $260.00 put option with a July 31 expiration. This strike price is 3.6% below Friday’s closing price of $269.76 and has a midpoint premium of $3.08 per contract (representing $308.00 for 100 shares).
If an investor sells this put, they immediately receive the $308.00 premium. This requires setting aside $26,000 (100 shares * $260.00 strike price) as collateral with their brokerage firm. If MCD’s stock price remains above $260.00 until expiration, the put expires worthless, and the investor keeps the premium as profit. If MCD falls below $260.00, the investor may be assigned to purchase 100 shares at $260.00. However, the effective breakeven price is lower due to the premium received:
- $260.00 (strike price) – $3.08 (premium) = $256.92 breakeven
This net breakeven is 4.76% below Friday’s closing price, offering a buffer against moderate declines. Repeatedly executing this strategy over several months could yield substantial income. For instance, if this trade is replicated for six consecutive months, the cumulative income would be approximately $18.48 ($3.08 x 6).
Leveraging with In-the-Money Calls
The income generated from selling OTM puts can be strategically used to offset the cost of purchasing in-the-money (ITM) call options. ITM calls provide leveraged exposure to the stock’s upside while reducing the upfront capital outlay when combined with put-selling income.
For example, a 6-month ITM MCD call option expiring on December 18, 2026, with a strike price of $260.00, has a midpoint premium of $23.98. If an investor uses the $18.48 generated from six months of selling puts, the net cost of this call option is significantly reduced:
- $23.98 (call premium) – $18.48 (put income) = $5.50 net cost
This strategy effectively reduces the net buy-in point for the call to just $265.50 ($260.00 strike + $5.50 net cost), which is below the current market price of $269.76. This setup implies substantial potential returns if MCD reaches our price target of $299.16:
- Intrinsic Value at PT: $299.16 – $260.00 (call strike) = $39.16
- Potential Profit: ($39.16 / $5.50 net call option cost) – 1 = 7.12x – 1 = 612% profit
This highlights the leveraged profit potential achievable through a combined options strategy, assuming the consistent generation of premiums from shorting OTM puts. The bottom line is that MCD stock, particularly given falling gas prices and its strong FCF, still appears undervalued. Strategic use of OTM puts and ITM calls offers a potent combination for investors seeking leveraged exposure and income generation in McDonald’s.
Frequently Asked Questions (FAQ)
Q1: What is Free Cash Flow (FCF) and why is it important for stock valuation?
A: Free Cash Flow (FCF) is the cash a company generates after covering its operating expenses and capital expenditures. It’s a key metric for valuation because it represents the cash available to shareholders, bondholders, or for reinvestment, indicating the true financial performance and health of a business. A higher FCF suggests a company has more flexibility for growth, debt reduction, or shareholder returns.
Q2: How do falling gas prices affect a company like McDonald’s (MCD)?
A: Falling gas prices typically benefit companies in the consumer discretionary sector, like McDonald’s, by increasing consumers’ disposable income. When fuel costs decrease, individuals and families have more money available for non-essential spending, such as dining out, which can lead to increased sales and improved financial performance for fast-food chains.
Q3: What are out-of-the-money (OTM) puts and in-the-money (ITM) calls, and what are their primary uses in investment strategies?
A: An out-of-the-money (OTM) put option has a strike price below the current market price of the underlying asset. Investors sell OTM puts to collect premium income, betting that the stock price will stay above the strike price, or that if it falls, they are willing to buy it at that lower strike price. An in-the-money (ITM) call option has a strike price below the current market price of the underlying asset. Investors buy ITM calls to gain leveraged exposure to the stock’s upside, as they already possess intrinsic value and can generate substantial profits if the stock price rises further.
