McDonald's A Buy, But 3 Challenges Remain Even After Earnings Bounce Back

Though fast-food behemoth McDonald’s (NYSE:MCD) has bounced back from the COVID-driven crash in earnings, the company still faces three challenges that continue growing.

First, employers in the United States are encountering what appears to be a radical shift in the domestic labor market. Workers are simply not interested in lower-paying service jobs. At a 14.97% , remarkably close to the consensus 12-month outlook.

Market-Implied Outlook for MCD/h2

I have analyzed the prices of put and call options at a range of strike prices, all expiring on January 21, 2022, to generate the market-implied outlook for MCD for the next 2.9 months (from now until that expiration date). I have also calculated the market-implied outlook for the 7.7-month period from now until June 17, 2022 using quotes on options that expire on that date. I selected these two periods to provide a view to early- and mid-2022 and because the options that expire on these dates tend to be quite liquid.

The standard presentation of the market-implied outlook is in the form of a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for MCD for the 2.9-month period from now until Jan. 21, 2022

Source: Author’s calculations using options quotes from ETrade

The market-implied outlook to Jan. 21, 2022 is generally symmetric, indicating that the the consensus outlook from the options market is fairly balanced, although the peak in probability is slightly tilted towards positive returns. The maximum probability corresponds to a price return of +1% over the next 2.9 months. The annualized volatility calculated from this distribution is 19.6%.

To make it easier to directly compare the probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Market-implied price return probabilities for MCD for the 2.9-month period from now until Jan. 21, 2022. The negative return side of the distribution has been rotated about the vertical axis

Source: Author’s calculations using options quotes from ETrade

This view shows that even though the peak probability return is only slightly above zero, the probabilities of positive returns are consistently higher than for negative returns for a wide range of the most-probable outcomes (the solid blue line is above the dashed red line for returns with highest probabilities). This is a bullish view from the market-implied outlook.

Theoretically, the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus overpay for put options. With this effect in mind, the market-implied outlook would be more bullish than it appears.

Looking out to the middle of 2022, using options that expire on June 17, 2022, the market-implied outlook for MCD is even more bullish, with higher probabilities of positive returns relative to negative returns for returns in the range from -20% to 20% (returns from 0% to 20% on the chart below). The probability of large-magnitude negative returns is higher than for positive returns, a standard characteristic of dividend-paying stocks. The annualized volatility derived from this outlook is 21.7%.

Market-implied price return probabilities for MCD for the 7.7-month period from now until June 17, 2022. The negative return side of the distribution has been rotated about the vertical axis

Source: Author’s calculations using options quotes from ETrade

The market-implied outlook for MCD suggests a moderately bullish view to early 2022, becoming more bullish as the year progresses. The expected volatility is low, albeit increasing slightly from the January outlook to the June outlook.

Summary/h2

Despite labor shortages and rising food commodity prices, both of which squeeze earnings potential from restaurants, the outlook for MCD looks solid. The Wall Street analyst consensus rating is bullish and the consensus 12-month price target is 12.9%, for an expected total return of 15.2%.

The market-implied outlook for MCD is bullish, with the positive outlook stronger by mid-2022 than at the beginning. The expected volatility derived from the market-implied outlook is about 21%.

As a rule of thumb for a buy rating, I want to see an expected 12-month total return that is at least half the expected volatility. Taking the analyst consensus price target at face value, MCD substantially exceeds this threshold.

Even looking at the lower expected returns from the dividend discount model (aka the Gordon Growth Model), MCD is on the threshold for a buy rating. With the bullish outlook from Wall Street and the options market, along with MCD’s solid earnings recovery coming out of COVID, I am assigning a buy rating on MCD.

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Written By: Geoff Considine, Ph.D