McDonald's Corp (MCD) stock looks undervalued. The dividend yield is 2.44%, well over its historical average, giving it at least an 11% upside. Moreover, selling short out-of-the-money (OTM put options can bring extra income for value investors. This can help pay for long-dated calls (over one year away in expiration), to benefit from the upside in MCD stock.
MCD is trading for $289.56 in midday trading on Dec. 31, 2024. This is well off its recent high of $316.56 on Oct. 18. However, it could be worth over 11% more at $321.82.
As a result, there is good reason to believe that the stock could rise again. This article will explain why and how to play this for the long-term shorting nearby OTM put options and investing in long-dated in-the-money (ITM) call options.
Dividend Yield Valuation
One reason MCD stock looks undervalued is that its average yield has been 2.20% over the past four years, according to Seeking Alpha. Similarly, Morningstar shows that its average 5-year yield has been 2.23%.
I wrote about this in my last two Barchart articles, including this one on Nov. 26, “McDonald's Corp Stock is Treading Water - Ideal for Investors Shorting OTM Puts for Income,” as well as this one on Nov. 3.
The point is that McDonald's Corp has recently raised its dividend by 6% to $7.08 per share.
As a result, the stock could be worth $321.82 per share. Here's why:
$7.08 / 0.022 = $321.82 target price
Using the average yield of 2.20% it has had in the past 4 years gives MCD a target price +11.1% higher than today.
Strong Free Cash Flow Covers the Dividend
Moreover, the company can easily afford this dividend. For example, over the last 12 months (LTM) McDonald's Corp has generated $6.58 billion in free cash flow (FCF). That comes from Seeking Alpha's LTM financial stats for its cash flow.
It produced $9.3 billion in operating cash flow, and after $2.725 billion in capex spending, its FCF was $6.580 billion.
This is well over the $4.81 billion it paid in LTM dividends. Moreover, even with the 6% increase this year in dividend payments, the new payout will still be just $5.1 billion.
In other words, there should still be plenty of FCF to cover these dividends, even if its FCF doesn't grow (i.e., $6.58 billion FCF/$5.1b dividends = 1.29x). But let's look at that.
Its LTM FCF margin was 25.7% (i.e., $6.58 billion FCF / $25.571 billion in LTM sales). Analysts now project next year's sales will grow to $27.04 billion, up from $26.07 billion projected for 2024.
Therefore, here is how much FCF we can expect McDonald's Corp will generate:
0.257 x $27.04 billion = $6.95 billion FCF
That is 5.6% higher than its LTM FCF figure of $6.58 billion.
So, you can see why McDonald's Corp felt comfortable in raising its dividend by 6% to $5.1 billion: its FCF is expected to rise 5.6% to $6.95 billion. That will still leave plenty of room to keep buying back shares as well.
The bottom line is that MCD stock looks undervalued based on its easily affordable dividend.
Shorting OTM Puts
One way to play this is to sell short near-term put options in out-of-the-money (OTM) strike prices. That way you can set a lower buy-in target price and still get paid while waiting for the stock to fall.
I discussed this in my last article on Nov. 26. I suggested shorting the $290 strike price put option for $2.71 in premium for expiration on Dec. 20, three weeks later. At the time MCD stock was at $295.95, so it was less than 2.0% out-of-the-money.
This also meant that the short seller made an immediate yield of almost 1.0% (i.e., $2.71/$290.00 = 0.934%). In the end, on Dec. 20, MCD closed at $292.68. That meant the short-put play remained out-of-the-money, the put expired worthless, and the investor did not have to buy shares at $290.
This play can be repeated, albeit at a lower strike price. For example, look at the Jan. 24, 2025, expiration - just 24 days from now - i.e., over three weeks away. It shows that the $280 strike price has a bid-side premium of $1.60.
That gives the short seller an immediate yield of 0.57% (i.e., $1.60/$280.00).
That is not as high a yield as before. However, there is one way this can be helpful to a long-term investor.
Buying long-dated in-the-money (ITM) calls along with this short-put play is a way to gain upside if MCD turns around over the next year. For example, look at the Jan. 16, 2026, call option expiration period.It shows that the $270 strike price call options have a premium of $37.75 per call contract.
That is in-the-money (ITM) since MCD stock is trading for $289.81, i.e., $19.81 higher. This means there is $19.81 in intrinsic value in the $37.75 price paid, or over half of the price ($19.81/$37.75 = 52.3%). This also means there is $17.94 in extrinsic value or extra price paid for the call option.
Moreover, if the investor can successfully short puts for $1.60 every 3 weeks over a year, i.e., 17 x, they can generate $27.20 in income. That will more than pay for the $17.94 in extrinsic value in the call.
The bottom line is that shorting these OTM puts is one way to help pay for a long-dated call in MCD stock. So, even if the stock moves only slightly higher there is a good possibility of making a good return over the next year.
This is worth tracking over the next year to see how well this performs. I suspect that given the stock's higher target price it is a good way to play the upside.
