Thirteen stocks were added to our Dividend Growth Stocks Model Portfolio this month, which was made available to members on August 26, 2022.
Recap From July’s Picks
On a price return basis, our Dividend Growth Stocks Model Portfolio (+1.7%) underperformed the S&P 500 (+1.9%) by 0.2%, and on a total return basis, the Model Portfolio (+2.0%) outperformed the S&P 500 (+1.9%) by 0.1%. The best performing stock was up 16%. Overall, 12 out of the 30 Dividend Growth Stocks outperformed the S&P 500 from July 28, 2022 through August 24, 2022.
This model portfolio mimics an “All Cap Blend” style with a focus on dividend growth. Selected stocks earn an Attractive or Very Attractive rating, generate positive free cash flow (FCF) and economic earnings, offer a current dividend yield >1%, and have a 5+ year track record of consecutive dividend growth. This model portfolio is designed for investors who are more focused on long-term capital appreciation than current income, but still appreciate the power of dividends, especially growing dividends.
Featured Stock From August: McDonald's Corporation (MCD: $256/share)
McDonald's Corporation (MCD) is the featured stock from August’s Dividend Growth Stocks Model Portfolio.
McDonald’s has grown economic earnings by 10% compounded annually over the past five years. McDonald’s net operating profit after-tax (NOPAT) margin rose from 24% in 2016 to 37% over the trailing twelve months (TTM), while the company’s return on invested capital (ROIC) rose from 14% to 18% over the same time.
Figure 1: McDonald’s Economic Earnings Since 2016
Sources: New Constructs, LLC and company filings
FCF Exceeds Dividends by a Wide Margin
McDonald’s has increased its dividend in each of the past 46 years. The company increased its regular dividend from $3.83/share in 2017 to $5.25/share in 2021, or 8% compounded annually. The current quarterly dividend, when annualized, equals $5.52/share, and provides a 2.2% dividend yield.
More importantly, McDonald’s strong free cash flow (FCF) easily exceeds the company’s growing dividend payments. From 2017 – 2021, McDonald’s cumulative $28.2 billion (15% of current market cap) in FCF is 60% more than the $17.6 billion in dividends paid out, per Figure 2. Over the TTM, the company generated $9.2 billion in FCF and paid out $4.0 billion in dividends.
Figure 2 also shows that McDonald’s FCF significantly exceeded its dividend payments in four of the past five years.
Figure 2: Free Cash Flow vs. Regular Dividend Payments
Sources: New Constructs, LLC and company filings
Companies with FCF well above dividend payments provide higher quality dividend growth opportunities because we know the company generates the cash to support a higher dividend. On the other hand, the dividend of a company where FCF falls short of the dividend payment over time cannot be trusted to grow or even maintain its dividend because of inadequate free cash flow.
McDonald’s Has Upside Potential
At its current price of $256/share, MCD has a price-to-economic book value (PEBV) ratio of 1.5. This ratio means the market expects McDonald’s NOPAT to grow no more than 50% above current levels. This expectation seems overly pessimistic for a company whose TTM NOPAT is 66% above 2015 levels.
If McDonald’s maintains its TTM NOPAT margin of 37% and grows NOPAT by just 5% compounded annually for the next fifteen years, the stock would be worth $315+/share today – a 23% upside. See the math behind the reverse DCF scenario.
Should the company grow NOPAT more in line with historical growth rates, the stock has even more upside. Add in McDonald’s 2.2% dividend yield and history of dividend growth, and it’s clear why this stock is in August’s Dividend Growth Stocks Model Portfolio.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Below are specifics on the adjustments we make based on Robo-Analyst findings in McDonald’s 10-Ks and 10-Qs:
Income Statement: We made $2.8 billion in adjustments with a net effect of removing $988 million in non-operating expenses (4% of revenue). Clients can see all adjustments made to McDonald’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: We made $12.8 billion in adjustments to calculate invested capital with a net decrease of $1.6 billion. The most notable adjustment was $2.8 billion (6% of reported net assets) in asset write-downs. Clients can see all adjustments made to McDonald’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: We made $50.0 billion in adjustments with a net effect of decreasing shareholder value by $47.0 billion. Apart from total debt, the most notable adjustment to shareholder value was $1.4 billion in excess cash. This adjustment represents <1% of McDonald’s market value. Clients can see all adjustments to McDonald’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
This article originally published on September 1, 2022.
Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Brian Pellegrini receive no compensation to write about any specific stock, style, or theme.
 Our research utilizes our Core Earnings, a more reliable measure of profits, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan and published in The Journal of Financial Economics.