A company's quality is more important than the valuation of its stock. After all, a junk company at a great price is still a junk company -- not exactly the kind that investors should hitch their financial wagons to for the long haul. However, the price investors pay for a stock is still important.
Consider that Warren Buffett is one of the greatest investors ever and has an enviable track record of success. But in 2019, Buffett admitted to CNBC that Heinz, under his direction, overpaid when acquiring Kraft in 2015. Since the acquisition was announced in March 2015, Kraft Heinz stock is down over 50% even though the S&P 500 index has more than doubled.
Buffett owns a lot of Kraft Heinz stock, which consequently impacts the long-term growth rate of his investment portfolio. Buffett would still say that Kraft Heinz is a great company. But in overpaying for Kraft, investment returns were set back.
There are plenty of stocks that I believe are too expensive today. The three I've chosen for this article are chicken wing restaurant chain Wingstop (WING 0.66%), newly public Mediterranean restaurant chain Cava Group (CAVA 0.92%), and semiconductor maker Nvidia (NVDA +5.93%). Here's why investment returns could be muted for these three companies from here.
1. Wingstop
Wingstop has everything anyone would ever want in a restaurant stock. Most of the company's 2,000 locations are franchised, allowing for a low-cost path to rapid expansion. Its operating margin is stellar at 23.6% in the first quarter of 2023. The concept is popular with consumers considering same-store sales have increased for 19 consecutive years.
And it has a huge goal of operating 7,000 locations worldwide someday, which would place it in the top 10 largest restaurant brands. In summary, Wingstop is popular, profitable, predictable, and has sky-high potential.
NASDAQ: WING
Key Data Points
Unfortunately, the stock is also priced beyond perfection. As of this writing, Wingstop trades at about 100 times its trailing earnings. For perspective, the average price-to-earnings (P/E) valuation for stocks in the S&P 500 is about 22. In other words, if Wingstop quadrupled its earnings per share (EPS) tomorrow, it would still trade at an above-average P/E valuation of 25.
Wingstop's growth should be great over the next five years. But I don't believe quadrupling its EPS would be an even remotely realistic expectation for shareholders. Consider that the company only doubled its EPS over the past five years. And doubling its EPS again over the next five years would be an admirable accomplishment.
WING EPS Diluted (TTM) data by YCharts
Wingstop stock could go up and beat the market from here. But if it does, it will likely still be trading at an outrageous valuation. Therefore, since the valuation doesn't make sense to me today, even when projecting big growth, this is a stock I'm avoiding.
2. Cava Group
Cava is a smaller restaurant chain with a little over 260 locations, and it just had its initial public offering (IPO) in June. I'm not concerned that it's still losing money -- the company had an almost $60 million net loss in its fiscal 2022. But for perspective, Chipotle Mexican Grill was a money-losing brand as well when it had fewer than 300 locations. As it scaled, it became profitable -- and the same could be true of Cava in time.
NYSE: CAVA
Key Data Points
However, Cava stock is clearly too expensive when just applying a little common sense. Consider that investment bankers are incentivized to raise as much money as possible for an IPO stock when it goes public. The Cava IPO was expected to price at $20 per share at best, but it priced 10% higher at $22 per share.
As of this writing, Cava stock trades at about $40 per share -- double what financially motivated investment bankers believed they could get just one month ago. I'd argue that with those incentives, $20 per share would have been generous. At $40 per share, it's unreal.
Cava has about $608 million in trailing-12-month revenue. With a market capitalization of $5 billion, the stock trades at around 8.2 times trailing sales. For perspective, Chipotle Mexican Grill stock often gets labeled as an overvalued stock. But the highest price-to-sales (P/S) ratio it's ever had was 8.1. Therefore, Cava stock is more expensive than Chipotle stock has ever been.
CMG PS Ratio data by YCharts
It's common for IPO stocks to trade at high valuations shortly after going public. In time, the valuations often come back down to Earth, allowing for much better entry points. For Cava, it hopes to get to 1,000 locations by 2032, so there is a big growth opportunity here. But I'll patiently wait for a better price.
3. Nvidia
I'm willing to bet that many readers will agree with my assessment of Wingstop and Cava. But many will likely disagree with my view on Nvidia stock. Nvidia has strong supporters and is one of the hottest stocks on the market, with shares gaining 190% year to date.
NASDAQ: NVDA
Key Data Points
The chip maker is benefiting from the market's excitement regarding artificial intelligence (AI). Some are calling AI the "fourth industrial revolution," capable of being an $800 billion market this decade. For its part, Nvidia supplies semiconductor components that are useful for AI applications, and the company is already getting a financial boost from the trend. Management expects to generate $11 billion in revenue for its upcoming fiscal second quarter of 2024. That would be astounding 64% year-over-year growth.
However, trading at a P/S ratio of 41, Nvidia stock has never been more expensive since going public in 1999.
NVDA PS Ratio data by YCharts
Let's suppose Nvidia trades at a P/S ratio of 20 in the future -- less than half of its current valuation but still well above its historical average. At that generous valuation, the company's revenue would need to quadruple in order for the stock to double.
Nvidia already generates tens of billions of revenue. If it quadrupled its revenue over the next seven years, it would be in elite company -- few companies have ever grown that fast, let alone at Nvidia's scale. But consider that over the long term the stock market itself doubles about every seven years on average. Therefore, if Nvidia stock quadrupled revenue and traded at a high valuation, it would still only be keeping pace with the market, not outperforming.
Simply put, I don't believe Nvidia stock offers a compelling entry point even for the most optimistic long-term investors.
To be clear, I wouldn't short Wingstop, Cava, or Nvidia. Stocks that are expensive now can still be expensive in the years to come. Moreover, all three of these companies have attractive traits -- they aren't bad companies.
That said, there are good companies that currently trade at much more attractive valuations. Therefore, I don't see a reason to buy these stocks today and unnecessarily assume high valuation risk.
Correction: The original version of this report misstated Cava's market cap. The comments on its valuation have been updated.
