Optimism is normally a good thing, and I would say I'm a "glass half full" kind of guy myself. However, I think I'm going to draw the line at Chipotle's (NYSE:CMG) valuation of 55 times earnings.
I would argue for days about how great the fast-casual business model is, and how Chipotle is changing the way we eat fast food. But price to earnings ratios of 55 should be reserved for highly speculative companies such as biotechs, not companies in the food industry with growth rates we could reasonably estimate.
The good in Chipotle
Chipotle has surged to this high valuation because of the promise it has offered consumers and investors. I'm not sure whether I would consider the fast-casual business model Chipotle employs revolutionary or evolutionary for fast food, but I'm leaning toward the latter. Either way, it is something new that consumers and investors love.
Being able to see your meal being made, knowing it is made with high-quality and healthy ingredients, and most importantly, having a delicious meal really struck a chord with consumers, as they file in with wallets wide open. This new trend in a little-changing food service industry has helped Chipotle grow revenues and net income by a whopping 16% and 21% per year over the last five years, respectively.
Chipotle also offers investors something fairly unique for a growth company: a clean balance sheet. At the end of 2013, the company had no long-term debt, and total liabilities only added up to $471 million, a small fraction of the $2 billion in assets it has.
The bad in Chipotle
The bad in Chipotle has nothing to do with Chipotle itself, but more with the basic economics involved. The first large player in a market, in this case Chipotle, enjoys robust growth and high margins, but when others see robust growth and high margins, competition ensues.
Chipotle's market is not protected by high barriers to entry; pretty much any average Joe with several thousand dollars or a good credit score could open a nice burrito restaurant if he or she wanted, and this is where the problem lies.
High competition brings lower top-line growth as market share is spread to others. High competition also creates pricing pressure, which can cause severe problems with bottom-line growth.
Chipotle is still the largest fast casual burrito chain, operating 1595 restaurants at the end of 2013, and with plans to open 180 to 195 more locations in 2014. The largest competitor to Chipotle is Qdoba Mexican Grill, run by Jack in the Box (NASDAQ:JACK)
Though Chipotle and Qdoba are the leading national brands, there are many other smaller competitors, such as Moe's Southwest Grill, Baha Fresh, Panchero's Mexican Grill, California Tortilla, and the list keeps going with smaller, more local chains.
The bottom line for Chipotle investors
If you have owned shares of Chipotle for the last few years, you've probably made quite a small fortune holding onto this company, and you may continue to make much more. However, all great things come to an end, and it may not be today, tomorrow, or this year even, but valuing shares of this company at 55 times earnings is extremely optimistic.
Earnings have been growing at around 20% a year for the last several years, but assuming this can continue for the long run is probably not a good idea. Chipotle has a great business model, consumers love it, and it is a very well-run company, but the introduction of higher competition leads me to believe not even the great Chipotle can keep growing at these marvelous rates.
I do not believe this company will crash and burn like a tech or biotech company that is overvalued; I simply believe Chipotle's earnings have quite a bit of climbing to do to catch back up with the valuation the market currently places on this great company.
Jacob Meredith has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. 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.