McDonald’s Corp. (MCD) has seen its stock decline, largely influenced by market apprehensions regarding the impact of elevated gas prices on consumer spending and, consequently, fast-food sales. However, recent trends suggest these fears may have been overstated, especially as gas prices begin to recede. A comprehensive analysis indicates MCD shares could be significantly undervalued, presenting opportune strategies for investors.
As of Friday, June 26, MCD closed at $269.76. This represents a recovery from its recent low of $264.54 on June 25, though it remains notably below its three-month peak of $311.36 recorded on April 17. The divergence between the current market price and fundamental valuation suggests a potential for upside.
Revisiting MCD Stock’s Intrinsic Value
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 MCD’s robust free cash flow (FCF) generation. FCF represents the cash a company generates after accounting for cash outflows to support its operations and maintain its capital assets. It’s a critical measure of a company’s financial health and its ability to pay dividends, repurchase shares, or reduce debt.
Based on analyst projections, MCD’s revenue is anticipated to range from $28.5 billion this year to $30.17 billion next year, translating to an estimated $29.335 billion over the next twelve months (NTM). Utilizing MCD’s historical average 26% FCF margin over the last year, the company is poised to generate approximately $7.63 billion in FCF.
To determine the Fair Market Value (FMV) of MCD, we apply a FCF yield of 3.6%. The FCF yield is calculated by dividing a company’s FCF by its market capitalization, essentially showing the cash return percentage an investor receives relative to the stock’s price. A lower FCF yield indicates a higher valuation, while a higher FCF yield may suggest undervaluation. Using this metric:
- $7.63 billion FCF / 0.0359 (FCF Yield) = $212.5 billion FMV
This calculated FMV of $212.5 billion is approximately 10.6% higher than McDonald’s reported market capitalization of $191.7 billion (according to Yahoo! Finance) on June 26. This disparity points to an implied price target (PT) of almost $300 per share:
- ($212.5 billion FMV / $191.7 billion Market Cap) = 1.1085
- $269.76 (Current Price) * 1.1085 = $299.06 PT (rounded to $299.16 in the original source)
This valuation aligns closely with other analyst targets, such as Yahoo! Finance’s average PT of $330.94, Barchart’s $330.59, and AnaChart’s $351.90. While these targets suggest significant upside, there’s no guarantee MCD will reach them.
Strategic Options Plays for MCD Stock
Given the potential undervaluation, investors can employ options strategies to capitalize on an anticipated rebound. One method involves selling one-month out-of-the-money (OTM) puts, which allows an investor to collect premium income while setting a lower potential entry price for the stock. An OTM put option has a strike price below the current market price, meaning the option holder would only exercise it if the stock price falls below that strike.
Selling Out-of-the-Money (OTM) MCD Puts
Consider the July 31 expiry $260.00 put option, which had a midpoint premium of $3.08 per contract. This strike price is 3.6% below MCD’s closing price on June 26, offering a buffer over the next 34 days. Selling this put option means:
- An investor commits $26,000 as collateral (for 100 shares at $260.00 strike) with their brokerage firm.
- The investor immediately receives $308.00 in premium income (100 shares * $3.08 premium). This income is kept regardless of whether the option is exercised.
- If MCD’s price falls to $260.00 or below, the investor may be assigned to buy 100 shares at $260.00. However, their effective breakeven purchase price is reduced by the premium collected: $260.00 – $3.08 = $256.92. This is 4.76% below the June 26 closing price.
Leveraging with In-the-Money (ITM) MCD Calls
This strategy can be combined with buying a longer-term in-the-money (ITM) call option, using the income generated from selling puts to offset its cost. An ITM call option has a strike price below the current market price, meaning it already has intrinsic value. Assuming an investor can consistently sell similar OTM puts for the next five months, the cumulative income would be $18.48 ($3.08 x 6 months).
For instance, a December 18, 2026, expiry $260.00 call option carried a midpoint premium of $23.98. If the investor uses the projected $18.48 from selling puts to cover part of the call option cost, the net cost of the call becomes just $5.50 ($23.98 – $18.48). This significantly lowers the effective entry point for the call option, making the net buy-in price ($260.00 strike + $5.50 net cost) equal to $265.50, which is below MCD’s closing price of $269.76. This strategy, however, relies on the assumption of consistent high premiums from OTM puts over six months.
Should MCD reach our price target of $299.16 by the December expiry, the call option would have an intrinsic value of $39.16 ($299.16 – $260.00). Relative to the net cost of $5.50, this would yield a substantial leveraged profit:
- $39.16 (Intrinsic Value) / $5.50 (Net Call Cost) – 1 = 7.12x – 1 = 612% profit.
In essence, McDonald’s stock appears undervalued based on its FCF potential. Implementing a disciplined options strategy involving selling OTM puts and buying ITM calls can provide a leveraged approach for investors looking to capitalize on MCD’s anticipated rebound.
Frequently Asked Questions (FAQ)
1. What is Free Cash Flow (FCF) and why is it important for valuation?
Free Cash Flow (FCF) is the cash a company generates after covering its operating expenses and capital expenditures (CapEx). It represents the cash available to shareholders, debt holders, and other stakeholders. FCF is crucial for valuation because it indicates a company’s ability to create value for its owners without relying on external financing. A consistently strong and growing FCF is often a sign of a healthy, efficient, and profitable business.
2. What are out-of-the-money (OTM) puts and in-the-money (ITM) calls?
- An **Out-of-the-Money (OTM) put option** is a put option whose strike price is below the current market price of the underlying asset. Selling an OTM put allows an investor to collect a premium, hoping the stock price stays above the strike price, letting the option expire worthless. If the price falls below, the investor might be obligated to buy the stock at the (higher) strike price.
- An **In-the-Money (ITM) call option** is a call option whose strike price is below the current market price of the underlying asset. ITM calls already have intrinsic value and are more expensive than OTM calls but offer a more direct way to profit from an expected price increase, as a portion of their value is already ‘in the money’.
3. How do gas prices impact McDonald’s stock performance?
Gas prices directly influence consumer discretionary spending. When gas prices are high, consumers typically have less disposable income for non-essential purchases, including dining out at places like McDonald’s. This reduction in consumer spending can lead to lower sales volumes and reduced profitability for fast-food chains. Conversely, falling gas prices can free up consumer budgets, potentially boosting sales and positively impacting a company’s stock performance, as seen with recent observations for MCD.
