Sales plunged at Chipotle Mexican Grill (CMG -6.22%) in the early months of the COVID-19 pandemic, as stay-at-home orders disrupted restaurant traffic. However, the fast-casual giant quickly pivoted to an emphasis on takeout and delivery: especially orders through its digital platforms.

On Wednesday, Chipotle released its third quarter earnings report. The results confirmed that its growth initiatives are working. Nevertheless, Chipotle stock slumped following the report: a reflection of its stretched valuation after a roughly 60% rally in 2020.

CMG Chart

Chipotle Mexican Grill year-to-date stock performance, data by YCharts.

Comp sales growth rebounds

In the second quarter, Chipotle's revenue fell 4.8% on a 9.8% decline in comparable restaurant sales. Yet nearly all of the damage came in April, when most of the U.S. was under stay-at-home orders. In its Q2 earnings report, Chipotle revealed that comp sales plunged 24.4% in April, fell 7% in May, and returned to growth in June, rising 2%.

That momentum continued in the third quarter, as comparable sales rose 8.3%. Chipotle also opened 44 new restaurants (and closed three others), contributing to a 14.1% increase in revenue to $1.6 billion. This roughly matched analysts' expectations.

Not surprisingly, Chipotle continues to lean heavily on digital sales to drive growth. Digital sales tripled last quarter, rising to 48.8% of total sales. That was split roughly evenly between delivery and order pickup. The company now has 128 restaurants equipped with "Chipotlane" drive-thru pickup windows. The rapid expansion of the Chipotlane concept has been a key driver of the growth in digital orders for pickup.

Solid earnings despite temporary headwinds

The pandemic has negatively impacted Chipotle's profitability in several ways. First, like other restaurants and retailers, Chipotle has had to implement enhanced cleaning procedures this year, adding new costs. Second, the sharp drop in sit-down dining has hurt its sales of drinks, which carry very high margins. Third, the explosion in delivery sales has weighed on margins, due to the added costs associated with delivery. (Chipotle has also reduced its delivery fees in response to the pandemic, aggravating this pressure.)

The interior of an empty Chipotle restaurant

Image source: Chipotle Mexican Grill.

Despite all of these headwinds, restaurant-level operating margin declined by just 1.3 percentage points year over year to 19.5%. Chipotle's revenue growth offset most of this margin pressure. As a result, adjusted earnings per share slipped just 1.6% to $3.76, easily beating the analyst consensus of $3.40.

As the COVID-19 pandemic abates, these margin headwinds should ease. Cleaning costs will moderate and the number of customers sitting down to eat at Chipotle will increase, boosting drink sales. The long-term trajectory of delivery as a percentage of sales is less clear, but Chipotle is already taking action to mitigate the margin impact of delivery sales by testing higher menu prices for delivery orders.

Plenty of growth potential -- but maybe not enough

CEO Brian Niccol said that the strong Q3 results validate his confidence in Chipotle's ability to eventually grow to more than 6,000 restaurants (up from 2,710 at the end of last quarter), with average unit volumes (AUVs) exceeding $2.5 million and restaurant-level operating margins of at least 25%.

These targets certainly do seem achievable, particularly with real estate availability improving dramatically due to the pandemic. Back in 2014, AUVs were already $2.5 million. (AUVs fell back to $1.9 million in 2016 due to food safety issues and have since recovered to $2.2 million.) The huge growth of Chipotle's digital business and menu price increases should enable Chipotle to far surpass this prior high over the long term. Furthermore, restaurant-level operating margin was 27.2% in 2014.

Even if Chipotle were to reach 6,000 restaurants with average unit volumes of $4 million and restaurant-level operating margins of 27% (with an all-in operating margin of 17%), that would only lead to $24 billion of revenue, $4.1 billion of operating income, and -- assuming a 27% effective tax rate -- net income of $3 billion. For comparison, Chipotle's market cap ended Thursday above $36 billion, despite a 5% share-price decline.

Thus, Chipotle stock trades for about 12 times what it might earn 10 or 15 years from now -- if things go well. That's simply too expensive. Chipotle is a great company with excellent growth prospects, but at current prices, the stock is unlikely to generate market-beating long-term returns.