Hidden Opportunity: This Stock's Sell-Off Signals a Buy

Key Points

• McDonald's stock recently fell into the consumer discretionary sell-off, but investors should consider whether this is justified.
• The company's recent financial performance suggests that the price should be much higher since there are no issues.
• Price targets and other technical factors show that Wall Street supports McDonald's in making a comeback.

It is no secret now that while most of the market is focused on the developments inside the technology sector, particularly around stocks exposed to the wave in artificial intelligence, other extremes in the market are feeling a bit of pain. Some of these forgotten and beaten down sectors include the consumer discretionary names, as judged by the 14% underperformance from the Consumer Discretionary Select Sector SPDR Fund NYSEARCA: XLY against the broader S&P 500 in the past year.

Leading this decline are stocks like Starbucks Co. NASDAQ: SBUX, PepsiCo Inc. NASDAQ: PEP, and Nike Inc. NYSE: NKE, all of which are trading near their 52-week low prices to showcase bearish momentum and price action. But all of these have enough reasons to sell off, some of which justify bearish traction, so investors need to look into those that are simply affected by outside—rather than inside—forces.

One perfect example can be found in McDonald’s Co. NYSE: MCD, especially now that the stock is trading within 3% of its 52-week low of $243.5 a share. While this weakness in the stock price may turn some investors away from even considering the stock, other savvy investors will find this a potential gem inside the sector sell-off.

Identifying the Weak Points in McDonald's Stock

There aren't many, and most are qualitative rather than hard facts. Qualitatively, the trend in global eating habits is toward healthier choices, which the McDonald's brand has yet to be known for. Quantitatively, this dietary trend isn't making a dent in the company's financials, at least not yet.

Looking into McDonald's' first quarter 2024 earnings results, investors can see that management began the press release by quoting a 2% comparable sales growth, making this quarter the thirteenth consecutive quarter of growth for the company. Chris Kempczinski, McDonald's CEO, reminded investors that the past four years have seen up to 30% revenue growth.

So, if the risks aren't coming from new dietary trends, where can investors find the blame for the recent sell-off? Fear of contracting margins, and therefore earnings per share (EPS), dominate McDonald's stock after the company decides to make a limited-time deal for a $5 meal.

A solidary move to help the inflation-choked American consumer created worries over accumulating losses through these discounts. Unfortunately, these fears are real, but one of McDonald's biggest partners is tending to them.

Granting up to $4.6 million in capital to subsidize temporary company and franchisee losses from this $5 menu, the Coca-Cola Co. NYSE: KO is securing part of its daily volume through McDonald's locations. Knowing that a loss for McDonald's could mean a loss for Coca-Cola's daily sales, this move makes enough sense for both companies.

Those are the only reasons behind McDonald's stock's sell-off; both have been addressed. The remaining blame could be credited to a systemic sell-off in peers like Starbucks and other discretionary names rather than a company-specific issue.

Analyzing McDonald's Stock Upside: What Investors Need to Know

Starting with some of the technical factors, investors can look at McDonald’s stock’s short interest, which has declined by over 4% in the past month alone. A withdrawal from short sellers, especially during a sell-off, can signify capitulation, typically followed by a bottoming and potential rebound.

Investors can also focus on what others on Wall Street have been doing lately. The UBS Group slapped a valuation for McDonald’s stock of up to $335 a share, daring it to rally by 32.5% from where it trades today.

While UBS is an outlier bull in its ratings, the consensus isn’t far from what those analysts see. A consensus price target of $312.8 a share still calls for a 23.8% upside from today’s stock price. The other nice thing, apart from a higher ceiling, from having a sell-off is that the stock’s dividend yield also goes up.

With a payout of $6.68 a share, McDonald’s stock offers investors an annual dividend yield of up to 2.6% today. This dividend yield would be enough for investors to beat the current U.S. GDP growth rate for the past quarter, which has been revised to only 1.3%.

Now comes the angle regarding valuation multiples, as it is safe to assume that investors understand that McDonald’s stock has enough upside today. On a price-to-earnings (P/E) ratio, McDonald’s stock trades at only 21.3x, whereas the rest of the eating places industry trades at a higher 33.1x P/E ratio.

McDonald’s is an undeniable moat and business moats typically trade at valuations that are multiples above industry averages. The tiebreaker score comes from the company’s financials, especially profitability ratios like return on invested capital (ROIC).

Pushing out a 20.6% ROIC rate would build the foundation for the stock’s recovery, as annual stock price performance tends to match the longer-term ROIC rate given enough time.