With shares up 51% in 2023 and 367% over the past five years, Chipotle Mexican Grill (CMG 1.03%) has done a fantastic job rewarding its shareholders. The stock has crushed the S&P 500 by an incredibly wide margin.
Chipotle continues posting strong financials, and its business appears to be firing on all cylinders right now despite the uncertain macroeconomic backdrop. Consequently, it might be difficult for investors to find any risks with this top fast-casual restaurant stock.
A closer look would reveal that there is, in fact, a huge downside risk with this company.
NYSE: CMG
Key Data Points
Chipotle's biggest risk might be obvious
Usually, a restaurant company faces huge risks resulting from intense competition. After all, it's harder to find a more competitive industry than the restaurant sector, with consumers having an unlimited number of choices in front of them when deciding how to satisfy their hunger. Then there are the sizable capital requirements and low margins to worry about.
In Chipotle's case, I believe the biggest risk for investors is how expensive the valuation is today. As of this writing, the stock trades at a price-to-earnings (P/E) ratio of 57. This is slightly more expensive than where shares have traded, on average, over the past 12 months. Plus, it represents a significant premium to the S&P 500's P/E multiple of 20 as well as other top restaurant stocks like Domino's Pizza (P/E of 26) and Starbucks (P/E of 31).
Everything else being equal, a high valuation reduces a stock's future return potential, and vice versa. Because everyone knows how great of a company this is, it's rare that shares would ever be selling at a low valuation. If all the optimism about Chipotle's prospects is fully priced in, and then some, there's no margin of safety in case the analysis is wrong. This also means that if the business were to disappoint Wall Street analysts with a subpar quarterly earnings announcement, shares could decline rapidly.
In the past five years, between 2017 and 2022, Chipotle's diluted earnings per share increased at a blistering annualized pace of 39%. This stellar performance has certainly helped propel the stock price.
Over the next five years, consensus estimates call for annual growth of 25%. Looking at Chipotle's PEG ratio of 2.3, which measures a stock's valuation relative to its growth outlook, it's evident that shares are expensive. A PEG ratio below 1 indicates an undervalued stock.
This is a high-quality company
A steep valuation can turn some investors away from even considering buying the stock. That's because it's hard to generate strong investment returns compared to if the share price had a more attractive valuation. But investors might look past Chipotle's high P/E ratio because of just how outstanding this enterprise is.
The last three years have been a wild roller-coaster ride for companies, especially restaurants. The pandemic forced locations to be shut down temporarily. Supply chain issues made it harder to find and buy necessary supplies to keep things running smoothly. Inflationary pressures increased prices for key inputs. And more recently, macro uncertainty has many thinking that a recession is in the not-too-distant future.
These negative factors haven't derailed Chipotle one bit. Between 2019 and 2022, revenue increased at a compound annual rate of 16%, with the lowest growth rate of 7% happening in pandemic-filled 2020. And the company's margins were much higher in 2022 than just three years earlier. Shareholders can sleep well at night knowing just how resilient this business has proven itself to be.
But it ultimately comes down to how much investors are willing to pay for such a high-quality company like Chipotle. If you're comfortable with the elevated P/E multiple, the stock deserves a closer look.
