Investors should look at valuation multiples when deciding whether to buy or sell a stock. Valuation multiples are driven by perceived growth, risk and uncertainties, and investors’ willingness to pay for a stock.
There are various multiples used to evaluate a stock. In this part, we’ll use the PE (price-to-earnings) multiple due to its high visibility in Chipotle Mexican Grill’s (CMG) earnings. The forward PE multiple is calculated by dividing the current share price by the forecast EPS (earnings per share) for the next 12 months.
Chipotle’s PE multiple
Despite the implementation of enhanced food safety measures and spending big on marketing and promotional activities, Chipotle posted SSSG (same-store sales growth) of -21.9% and adjusted EPS of $0.79—compared to analysts’ estimates of -17.5% and $1.56. After lower-than-expected 3Q16 results, analysts lowered their earnings estimates for the next four quarters by 10%. Investors were skeptical about its future earnings. It led to a fall in Chipotle’s share price and its PE multiple. As of October 26, Chipotle was trading at a PE multiple of 45x—compared to 46.3x before its 3Q16 earnings.
As you can see in the above graph, Chipotle is trading at a higher valuation multiple than its peers due to the fall in its estimated earnings. On October 26, 2016, peers such as Panera Bread (PNRA), Shake Shack (SHAK), and Brinker International (EAT) were trading at 25.9x, 57.6x, and 13.5x, respectively.
To improve its SSSG, Chipotle plans to enhance customers’ experience and implement menu innovations. The company launched a new menu item, chorizo, across the US on October 3, 2016. Chipotle plans to implement a digital ordering and payment system for its catering and delivery services. It’s expected to increase Chipotle’s expenses. If the initiatives don’t yield the desired SSSG, the increased expenses will likely put pressure on Chipotle’s margins.
Analysts expect the company to post EPS growth of 146% in the next four quarters. Chipotle’s current share price might have factored in the growth rate. If the company’s results are lower, the stock could face selling pressure. It could bring the PE ratio down.
You could mitigate company-specific risks by investing in the iShares Russell Mid-Cap Growth ETF (IWP). IWP invested 53.4% of its holdings in restaurants and travel companies. In the final part of this series, we’ll look at analysts’ recommendations for Chipotle after its 3Q16 earnings.
Next, we’ll look at analysts’ recommendations for Chipotle.