Could 1Q16 Results Stop Shake Shack’s Declining Valuation Multiple?

The valuation multiple helps investors decide whether to enter or exit a stock. A company’s valuation multiple is affected by its perceived growth, risk and uncertainties, and investors’ willingness to pay.

There are various multiples available. We’re using an enterprise value-to-sales ratio, as Shake Shack (SHAK) is still in the growth phase of its life cycle. During the growth phase, companies’ operating costs will be higher and EPS can’t be considered for the valuation.

So we use the forward EV-to-sales ratio, which is calculated by dividing the current enterprise value with forecasted sales for the next 12 months. Estimated future sales give more visibility to a company’s growth prospects.

Since its listing in January 2015, Shake Shack’s (SHAK) EV-to-sales multiple has been trading at 4.7x–18.5x. After listing, investor euphoria about the company’s growth prospects and expectations of future returns pushed SHAK’s stock up.

The company’s share price peaked at $96.80 on May 22, 2015. This increased its EV, which in turn pushed the EV-to-sales multiple up. Since then, share prices have fallen as investors grew skeptical of the company’s future growth prospects, which also brought the multiple down.

As of April 29, 2016, Shake Shack’s PE multiple was trading at an EV-to-sales multiple of 5.2x, closer to its lowest PE multiple. Being a nascent company and due to its high growth potential, SHAK maintained a high valuation multiple compared to the medians of peers such as Chipotle Mexican Grill (CMG), Panera Bread (PNRA), and Jack in the Box (JACK).

However, as investors grew skeptical about its growth prospects, the valuation multiple declined. We can see from the graph that the difference between the valuation multiple of Shake Shack and its peers is declining.

Shake Shack’s (SHAK) current share price may already have factored in future estimated sales of $242.4 million for the next 12 months. That represents a growth of 27.2% from $190.6 million in 2015.

If the 4Q15 results come in lower, then SHAK’s stock could face selling pressure. This could bring the EV-to-sales multiple down, and vice versa. You can mitigate these company-specific risks by investing in the Guggenheim S&P 500 Pure Growth ETF (RPG). RPG invested 44% of its investments in restaurants and travel companies.