As they are driven by growth prospects, investors’ willingness to pay, risks, and uncertainties, valuation multiples help investors in making investment decisions. Of the various valuation multiples, we’ll be using the forward EV-to-sales ratio (enterprise value to sales) because Shake Shack (SHAK) is in the growth phase of its business life cycle.
During the growth phase, a company will experience higher operating expenses, and so EPS (earnings per share) can’t fairly be considered in its valuation. The forward EV-to-sales ratio is calculated by dividing a company’s current enterprise value by its expected sales for the next 12 months.
SHAK’s EV-to-sales ratio
The better-than-expected 1Q17 earnings and the upgrade of its stock by Buckingham Research Group appear to have increased investors’ confidence in SHAK, leading to a rise in its stock price and its EV-to-sales ratio. As of May 5, 2017, Shake Shack was trading at a forward EV-to-sales ratio of 3.4x, as compared to 3.1x before the announcement of its 1Q17 earnings.
From the above graph, we can see that Shake Shack is trading above its peers’ valuation multiples. On the same day, Panera Bread (PNRA) and Chipotle Mexican Grill (CMG) were trading at EV-to-sales multiples of 2.4x and 2.7x, respectively.
As it is in a growth phase, Shake Shack has a huge scope for expansion. When growth expectations are higher, the market tends to value the company at a higher multiple.
SHAK’s growth prospects
To improve its same-store sales growth, Shake Shack has been focusing on enhancing its customer experience through the implementation of technological advancements, menu innovations, marketing, and promotional offers.
Such initiatives are expected to increase Shake Shack’s expenditures. But if these initiatives fail to generate the expected sales, the increased expenses could put pressure on its operating margin, thus lowering its earnings.
For the next four quarters, analysts are expecting SHAK to post EPS growth of 6.3%. If the company’s earnings come in lower than the analysts’ estimates, selling pressure could lower its valuation multiple.
You can mitigate these company-specific risks by investing in the iShares US Consumer Services ETF (IYC), which has 11.2% of its total holdings in restaurant and travel companies.
In the next and final part, we’ll examine analysts’ recommendations and price targets.