Why Chipotle Is Severely Overvalued

Chipotle's massive popularity and fast growth have driven the stock to unrealistic levels in comparison with peers like Panera Bread, with optimism taking the place of fundamentals.

Mar 31, 2014 at 8:01AM

Shares of Chipotle Mexican Grill (NYSE:CMG) have been on a tear since the beginning of 2013, nearly doubling during that time. The chain of quick-service burrito restaurants has rapidly expanded while its earnings have grown at a blistering pace, and its over 1,500 locations generate $3.2 billion in revenue each year. While the popularity of Chipotle is undeniable, so too is the unrealistic valuation given to the shares by an overly exuberant market. While the company certainly has real growth prospects, the expectations of investors have sharply diverged from reality.

Comparing Chipotle
There is no doubt that Chipotle is a wonderful company and that its dedication to quality ingredients differentiates it from many of its peers. Operationally, Chipotle is top-notch with a high operating margin and an exceptional return on equity. However, the return that an investor achieves depends on the price paid for the shares, and in that regard Chipotle doesn't look so great. Here is a chart that compares Chipotle with Panera Bread (NASDAQ:PNRA), a smaller chain with similar characteristics, and McDonald's (NYSE:MCD), the global fast-food behemoth.

Chipotle Compare

Chipotle and Panera have a lot in common. Both are roughly the same size, both use high-quality ingredients, and both have similar operational metrics. Chipotle has a higher operating margin and Panera has a higher return on equity, but both have grown earnings at roughly the same rate over the past five years, around 25%-27%.

It's surprising, then, to see that Chipotle is trading at twice the P/E ratio of Panera. While Panera sports a P/E ratio of about 27, a high number but one that is possibly justifiable given the company's growth, Chipotle's P/E ratio of 54 simply makes no sense at all. This isn't some upstart tech company that we're talking about, it's a chain of fast-casual restaurants.

The arguments for Chipotle revolve around the company's fantastic growth prospects, not only with its namesake restaurants but also with the company's concept Asian restaurant, Shophouse. While the company certainly has plenty of room to grow, it will face significant challenges as it becomes larger.

First, one of Chipotle's main draws is the quality of its ingredients, and as the company grows larger it will become more difficult to source high-quality ingredients. The company has already had some issues on this front, as a shortage of antibiotic-free cows caused its stores to occasionally resort to serving conventionally raised beef. This problem will only get worse as Chipotle grows, and maintaining Chipotle's rapid growth may require sacrifices on the quality front which would thus diminish the company's key advantage.

Another issue is the question of whether or not the Chipotle concept translates well to international markets. Almost all of Chipotle's restaurants are in the United States, with just 16 locations in other countries. There are two conclusions that can be drawn from this. First, the company has a huge opportunity in international markets. Second, the Chipotle brand is unproven outside of the United States.

There is no guarantee that Chipotle can achieve the same success abroad as it has in the United States, and investors should not treat this as a foregone conclusion. Another issue, going back to my first point, is that sourcing quality ingredients in markets like China and India is likely far more difficult than it is in the United States. The assumption that Chipotle won't enter markets abroad in a meaningful way until the ingredients become available may mean slower growth than many assume.

Chipotle has impressive margins, with its 16.5% operating margin besting that of Panera by about 3.5 percentage points. Looking at McDonald's metrics, it would appear that Chipotle still has plenty of room to grow its margins. McDonald's managed an operating margin in excess of 30% in 2013, nearly twice that of Chipotle. However, McDonald's has a very different business model than Chipotle, with a large portion of its restaurants franchised. Chipotle owns all of its restaurants, so the company will never even come close to McDonald's margins. McDonald's makes a lot its money by collecting franchise fees and rent, not selling burgers, and that's why the company's margins are so high. If anything, the difficulty in sourcing quality ingredients will lead to higher food prices and lower margins for Chipotle in the future.

The bottom line
Chipotle is a wonderful, well-run company, but investors are ignoring the issues that could sabotage the kind of growth that a P/E ratio of 54 demands. Chipotle trades at twice the P/E ratio of Panera, a company with similar characteristics, which is a clear sign that optimism has driven Chipotle's stock price up too high. Can the stock go higher? Sure. However, the stock no longer reflects the company's fundamentals, and that's a dangerous situation for overzealous investors.

6 stock picks poised for incredible growth
They said it couldn't be done. But David Gardner has proved them wrong time, and time, and time again with stock returns like 926%, 2,239%, and 4,371%. In fact, just recently one of his favorite stocks became a 100-bagger. And he's ready to do it again. You can uncover his scientific approach to crushing the market and his carefully chosen six picks for ultimate growth instantly, because he's making this premium report free for you today. Click here now for access.

Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers