Bes Stocks To Buy 2014, Best Stocks For 2014: What McDonald's Does With Its Cash

Thursday, March 1, 2012

What McDonald's Does With Its Cash

In the quest to find great investments, most investors focus on earnings to gauge a company's financial strength. This is a good start, but earnings can be misleading and incomplete. To get a clearer understanding of a company's ability to earn money and reward you, the shareholder, it's often better to focus on cash flow. In this series, we tear apart a company's cash flow statement to see how much money is truly being earned, and more importantly, what management is doing with that cash.

Step on up, McDonald's (NYSE: MCD ) .

The first step in analyzing cash flow is to look at net income. McDonald's net income over the last five years has been impressive:

�	2011*	2010	2009	2008	2007
Normalized Net Income	$4.8 billion	$4.4 billion	$3.9 billion	$3.7 billion	$3.3 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

Next, we add back in a few non-cash expenses like the depreciation of assets, and adjust net income for changes in inventory, accounts receivable, and accounts payable -- changes in cash levels that reflect a company either paying its bills, or being paid by customers. This yields a figure called cash from operating activities -- the amount of cash a company generates from doing everyday business.

From there, we subtract capital expenditures, or the amount a company spends acquiring or fixing physical assets. This yields one version of a figure called free cash flo! w, or th e true amount of cash a company has left over for its investors after doing business:

�	2011*	2010	2009	2008	2007
Free Cash Flow �	$4.5 billion	$4.2 billion	$3.8 billion	$3.8 billion	$2.9 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

Now we know how much cash McDonald's is really pulling in each year. Next question: What is it doing with that cash?

There are two ways a company can use free cash flow to directly reward shareholders: dividends and share repurchases. Cash not returned to shareholders can either be stashed in the bank, used to invest in other companies, or to pay off debt.

Here's how much McDonald's has returned to shareholders in recent years:

�	2011*	2010	2009	2008	2007
Dividends	$2.5 billion	$2.4 billion	$2.2 billion	$1.8 billion	$1.8 billion
Share Repurchases	$3.5 billion	$2.7 billion	$2.8 billion	$3.! 9 bil lion	$3.9 billion
Total Returned To Shareholders	$6.0 billion	$5.1 billion	$5 billion	$5.7 billion	$5.7 billion

Source: S&P Capital IQ. *12 months ended Sept. 30. ��

As you can see, the company has repurchased a fair amount of its own stock. That's caused its shares outstanding to fall:

�	2011*	2010	2009	2008	2007
Shares Outstanding (millions)	1,040	1,066	1,092	1,127	1,188

Source: S&P Capital IQ. *12 months ended Sept. 30.

Now, companies tend to be fairly poor at repurchasing their own shares, buying feverishly when shares are expensive and backing away when they're cheap. Does McDonald's fall into this trap? Let's take a look:

Source: S&P Capital IQ.

Despite some quarter-to-quarter volatility, McDonald's has been fairly consistent with its buybacks, regardless of share price. At about 18 times earnings, shares aren't exactly cheap these days, so repurchases at current prices might not be getting shareholders much bang for their buck. I'd like to see more cash devoted to the dividend, but in general, I'd say McDonald's management has done a fai! r job wi th share repurchases.

Finally, I like to look at how dividends have added to total shareholder returns:

Source: S&P Capital IQ.

Over the last five years, McDonald's shares returned 160%, which drops to 124% without dividends -- not a bad boost to top off already extraordinary share performance.

To gauge how well a company is doing, keep an eye on the cash. How much a company earns is not as important as how much cash is actually coming in the door, and how much cash is coming in the door isn't as important as what management actually does with that cash. Remember, you, the shareholder, own the company. Are you happy with the way management has used McDonald's cash? Sound off in the comment section below.