This article is part of our Rising Star Portfolios Series.

A lot of people might look askance at you if you claimed that a stock trading at nearly 50 times earnings could be a reasonable buyout candidate. Yet that's exactly what I'm claiming will probably happen to Red Robin Gourmet Burgers (NYSE: RRGB). That deceptively high P/E ratio disguises the company's ability to generate a lot of cash, and a bevy of hedge funds own more than 20% of shares. And I've put the Fool's money where my mouth is, as it's part of my Special Situations portfolio.

While Red Robin may not have the high-growth profile that quick-service chains Chipotle (NYSE: CMG), McDonald's (NYSE: MCD), and Yum! Brands (NYSE: YUM) have, the sit-down burger concept does offer demonstrable value, as it slows expansion and focuses on producing free cash flow.




Red Robin 49.3 6.7
Chipotle 43.3 19.7
McDonald's 16.6 10.2
Yum! Brands 21.3 10.2

Source: Capital IQ, a division of Standard & Poor's.

McDonald's and Yum! offer well-managed opportunities for interesting international growth at reasonable, though not stellar, valuations. While Red Robin and Chipotle have comparable P/E ratios, the latter is clearly priced for much greater growth. In contrast, Red Robin has very little expectation priced into its stock. Even a modest improvement -- no buyout needed -- could push the stock up nicely.

But a buyout may well come. Just this morning, news was released that Oak Street Capital, which has a 13.3% share in the company, is agitating again for change. And Clinton Group, an 8.2% shareholder, has told the company to solicit buyout proposals. Such large shareholders have a powerful influence on management.

DCF analysis
I ran a 10-year discounted cash flow analysis (DCF) to get a feel for how the company was priced. Using trailing free cash flow of $42.2 million and extending that into perpetuity with 0% growth, Red Robin shares have a value of $22.50 at a 12% discount rate. Those are pretty modest assumptions, and the projected value still comes above current prices. A discount rate of 10% pushes that value up to $27 per share.

Using slightly more aggressive figures, Red Robin could be priced at $28 per share. That assumes growth in free cash flow to $55 million by year four and then no growth to perpetuity, all discounted back at 12%. For context, a discount rate of 10% pushes that value up to $34 per share. But I think a 12% rate is a safer way to go for this stock.

Foolish bottom line
Without particular aggressive assumptions, shares of Red Robin look underpriced. And that's the kind of situation I like to invest in: Against low expectations, even modest outperformance can send shares soaring. But we also have the added benefit of activist investors pushing for change and indeed a buyout, and that offers a clear catalyst for realizing the value of Red Robin. That's why I've picked up shares for my own portfolio, subject to the Fool's Rules, of course.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios) here.

Jim Royal, Ph.D., owns shares in Red Robin. Chipotle is a Motley Fool Rule Breakers recommendation. Chipotle is a Motley Fool Hidden Gems selection. The Fool owns shares of Chipotle and Red Robin. 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.