Chipotle Mexican Grill
But being a great company doesn't necessarily mean its stock is a buy. Just ask someone who's held Wal-Mart
The key is value
To answer the question of whether a stock like Chipotle is a buy, we use the price-to-earnings ratio to determine whether its shares are over- or undervalued. This metric estimates how much a prospective shareholder must pay for each dollar of a company's earnings. And by doing this, it makes it possible to compare a specific company's value relative to its peers and the broader market. In a very simplistic understanding of it, smart investors prefer companies with lower (as opposed to higher) relative P/E ratios.
Using this measure, in turn, it'd be easy to conclude that Chipotle's stock is overvalued. As you can see in the table below, with a forward P/E ratio of 38.7, a dollar of Chipotle's earnings are twice as expensive as McDonald's
Forward P/E Ratio
Net Margin (TTM)
Sources: Morningstar.com, Retailsails.com, and respective company websites. TTM = trailing 12 months.
It turns out, however, that this initial impression could very well be wrong. A Foolish colleague of mine, Adam Wiederman, recently discussed the risk of relying exclusively on the P/E ratio. The general problem, according to Adam, is that sometimes a company with a high P/E ratio may not actually be expensive.
Misleading, right? Take Amazon.com as an example. At the end of 2003, it traded for the sky-high multiple of 658 times earnings. Yet because of the Internet retailer's remarkable growth in the intervening time period, its shares have returned an astounding 290%.
Like Amazon, Chipotle's future growth could easily justify this multiple. With just over 1,200 restaurants, it has but a fraction of the locations operated by either Starbucks or McDonald's. By this measure, just taking a blind stab at it, one could reasonably envision an additional 2,000 outlets. Others have even tossed out 3,000 locations as the saturation point.
In addition, because the company is debt-free for all intents and purposes, equity holders needn't share any of the company's operating earnings with creditors via interest payments (as shareholders of most other companies must). In 2011, for example, creditors of Starbucks and McDonald's took home $33 million and $493 million, respectively.
Finally, though not insignificantly, all of the above excludes any potential profits from the burrito chain's Asian offshoot, ShopHouse. While the latter is still ostensibly a pilot program, if the success of the first location is any indication, there's reason to believe that it'll be extremely lucrative. Take it from me: The food is good and the place is often packed.
Bite that burrito
One of our guiding principles here at The Motley Fool is that investors should never shy away from investing in great companies like Chipotle. While its earnings multiple makes the burrito chain appear over-valued, its potential seems likely to exceed the expectations priced in. For another stock along these same lines, check out our recently released free report: "The Motley Fool's Top Stock for 2012." It profiles an under-the-radar company that our analysts believe could be a big-time multibagger. To access this report before it's no longer available, click here now -- it's free.
Fool contributor John Maxfield does not have a financial stake in any of the companies mentioned above. The Motley Fool owns shares of Panera Bread, Chipotle Mexican Grill, Starbucks, and Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores, Chipotle Mexican Grill, Starbucks, McDonald's, and Panera Bread. Motley Fool newsletter services have also recommended writing covered calls on Starbucks, creating a bear put spread position in Chipotle Mexican Grill, and creating a diagonal call position in Wal-Mart Stores. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.