How to Pick a Great Restaurant Stock

The process of finding a great stock can sometimes feel like trying to find a needle in a haystack. There are literally thousands of metrics to choose from. Do you look at top line? Bottom line? Solvency? Liquidity? Dividend yield? Margin? Profitability?

Indeed, after spending a few hours looking at figures like these, you're often no further along from where you started. If you've experienced this feeling, then I have good news for you: When it comes to investing, less is often more. And this is particularly true in the case of restaurant stocks, where there's one only thing you need to be concerned about.

Earnings.

The centrality of earnings
It may seem obvious that earnings are the most important metric when it comes to choosing a stock. But this isn't true for all investors. During the dot-com bubble, investors and stock analysts were so infatuated with technology companies that they flung earnings aside, as well as revenue for that matter, in favor of page views, or "eyeballs." We know how that ended.

Here's the reason earnings are so central: When you buy a stock, whether it's a restaurant stock or any other stock for that matter, you're staking a claim in the underlying company's present and future income. In other words, you're buying a right to the earnings themselves. That's it. No more, no less. If you internalize this single point, you'll be leaps and bounds ahead of your peers.

The quantity and quality of earnings
I've often found it useful to bifurcate an earnings analysis into quantitative and qualitative parts, as I've done in the following diagram.

On the quantitative side, you're concerned with a company's present and future earnings. Present earnings are objective; they're simply a company's reported earnings per share. Future earnings are more subjective, requiring you to make an educated guess about how much a restaurant chain can grow by increasing sales at existing stores (known as "same-store sales" or "comps" and discussed at length recently by three of our top analysts) and/or opening new ones.

Take Arcos Dorados (NYSE: ARCO  ) , the largest McDonald's (NYSE: MCD  ) operator in Latin America, as an example. In the just-concluded second quarter of this year, as I noted yesterday, the company reported earnings per share of $0.06, total revenue growth of 15.5% on a constant currency basis, and same-store sales growth of 10.4%, far outpacing the industry's average second-quarter comps of 3.3%. These are the types of numbers you want to see, and particularly if they continue.

On the qualitative side, you're concerned with profitability and reliability. The best metrics to gauge profitability are return on assets and net margin. Return on assets, computed by dividing a company's net income by its total assets, tells you how many dollars a company earns from each dollar of assets it controls. Net margin, computed by dividing a company's net income by its revenue, tells you how much of each dollar in sales the company keeps as a profit. In both cases, bigger is better.

The easiest way to assess reliability is to compare a company's cash and equivalents with its total debt load. When it comes to restaurant chains, with the exception of a McDonald's or Yum! Brands (NYSE: YUM  ) , both of which can maintain heavy debt loads given the predictability of their revenue streams, you want to see the former exceed the latter. The popular burrito chain Chipotle (NYSE: CMG  ) and wings purveyor Buffalo Wild Wings (Nasdaq: BWLD  ) offer textbook examples of this. Both have millions of dollars in cash -- $456 million and $60 million, respectively -- and effectively no debt.

Last but not least, though it isn't on the diagram, is the share price. Regardless of how good a particular company's earnings are, there's a limit to how much you should pay for them. The best way to assess this limit is through the price-to-earnings ratio, computed by dividing a company's share price by its earnings per share. The quotient reveals how much you have to pay for each dollar of earnings: The higher the ratio, the higher the price.

Foolish bottom line
Investing is an essential part of building wealth. But many investors don't have the time or energy to devote hours of research and analysis to it. As a result, using a simplified method, like the one I've outlined, can save time without short-changing your portfolio. And another way to save time picking stocks is to read our newest free report about three stocks our analysts are calling "middle-class millionaire-makers." Access this free report instantly.

Fool contributor John Maxfield owns no shares of any of the companies mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill, Arcos Dorados Holding, McDonald's, and Buffalo Wild Wings. Motley Fool newsletter services have recommended buying shares of McDonald's, Buffalo Wild Wings, and Chipotle Mexican Grill and writing covered calls on Buffalo Wild Wings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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  • Report this Comment On August 09, 2012, at 8:30 PM, ayalara wrote:

    One hallmark of a great company is a great moat. Unfortunately lots of newbies can cook great food. A big chain with a well-know name is a bit of a moat ... but it's mostly just customer momentum. Restaurant preferences can be as whimsically fickle as clothing fashion preferences.

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