It’s hard for anyone to deny how great an investment it is Chipotle Mexican Grill(NYSE:CMG) has been. Shares have soared higher in recent years on strong financial performance.
The fact that Chipotle has proven to be an excellent company that has built shareholder capital means it should be on your investment radar. However, it’s best to know one important caveat before purchasing this unstoppable restaurant inventory.
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Over the past five years, Chipotle stock is up 307%. That gain easily exceeds S&P500 by a wide margin, resulting in a total return of 111%. Even this year, Chipotle has outperformed the broader index.
But the warning sign investors should heed is Chipotle’s sky-high valuation. The stock is trading at a price-earnings ratio (P/E) ratio of 56.3 on November 12.
To be fair, this valuation is lower than the price-to-earnings ratio of 72.6 that the shares sold for at their all-time high in June this year. Some investors could see this slight pullback as a smart buying opportunity. But I don’t feel that way.
Chipotle’s expensive valuation means it’s out of the question safety margin for potential investors, in my opinion. It shows how much optimism and enthusiasm the market has for the company and its prospects. Based on Chipotle’s financial performance in recent years, this bullish outlook is understandable.
Investors should realize that a high price-to-earnings ratio is a major hurdle to achieving strong returns. In other words, it shows that Chipotle may be perfectly priced right now. Should same-store sales and margins turn out worse than the market expects in a given quarter, the shares will take a hit.
This begs the question: at what valuation is the stock a buy candidate? I would need to see the price/earnings ratio drop below 30 to get interested. I’m not sure this will ever happen. But I’ll keep an eye on Chipotle’s business and stock and wait patiently for the right opportunity.
It is important to separate the valuation of a stock from the underlying company. While the former isn’t attractive today, the latter points to an excellent company.
Chipotle has shown solid growth between the third quarter of 2019 and 2024, doubling revenue over the past five years. This is partly due to robustness sales in the same store profits. But it also comes from a rapidly growing retail base.
Since 2019, Chipotle has opened a net 1,069 new locations, many of which are built with drive-throughs called Chipotlanes. And the company still has a lot of expansion potential. Forecasts call for 7,000 stores in North America one day, which would double the current footprint.
Each Chipotle location continues to generate more sales each year. Therefore, it is easy to understand why the management team is so focused on further expanding the store base, especially since they also boast a restaurant-level margin of 25.5%.
This is a very profitable organization. Since the third quarter of 2019, net income has increased by 31.5% year-on-year. Chipotle is proving that it can operate exceptionally well, especially as it scales and better leverages its spend to drive ongoing efficiencies.
According to Wall Street analyst consensus estimates, earnings per share are expected to grow at a compound annual rate of 18.9% from 2024 to 2026. Even though that would be a notable slowdown, it is still a positive outlook. But it doesn’t justify paying the current price-to-earnings ratio.
There’s no doubt that Chipotle is a high-quality company. However, the valuation is currently unconvincing. Your best bet is to add this company to your watchlist in hopes of a significant pullback.
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Neil Patel and his clients have no positions in the stocks mentioned. The Motley Fool holds positions in and recommends Chipotle Mexican Grill. The Motley Fool recommends the following options: Short December 2024 put $54 on Chipotle Mexican Grill. The Motley Fool has a disclosure policy.
1 Warning Before You Buy This Unstoppable Stock was originally published by The Motley Fool
