Chipotle

I'm going to start off making a bold statement: There are two key -- yes, only two -- metrics Chipotle (NYSE:CMG) shareholders need to keep in mind when buying or selling shares. You'll be hard-pressed to see them reported in financial headlines, either.

But before I proceed, some background
I am a Chipotle fan. But I'm not necessarily talking about the food. After following the company -- and the larger fast-food industry -- for years, I've covered nearly every angle of analysis possible.

I've even gone so far as sitting down at Chipotle restaurants during lunch hours to record traffic counts and test the hypothesis that the company's same-restaurant sales had peaked.

After hours of these "channel checks," I built complex financial models that suggested with statistical significance the company's same-restaurant sales were inevitably going to decline. I couldn't have been more wrong, and my brokerage account was quickly worth a chunk less soon after shorting shares.

I came to a few realizations at that point:

  1. There is too much noise in the market.
  2. Long-term thinking is best.
  3. Financial models do little, if anything, but provide false confidence in what we already believe to be true.

So with that, I say this: Forget same-restaurant sales... forget skyrocketing corn, pork, avocado, or any other commodity cost... and lastly, forget quarterly results!

They just aren't that relevant for investors that measure their holding periods in five to 10-plus years.

But don't forget this: Restaurant-level operating margins and return on capital are metrics that matter.

Why only these two metrics?
Good management teams allocate capital effectively and increase shareholder value over time with smart investments. This is accomplished by earning a higher rate of return on an investment than the cost of its capital -- in Chipotle's case, the cost of its capital is 8.45%, according to GuruFocus; and its return on capital in the past 12 months is 25.6%, according to Morningstar. See below for a comparison against McDonald's (NYSE:MCD).

Roic

Source: Morningstar.

At the risk of oversimplifying complex economics with just one number, Chipotle earns 17.1% annually on its investments, which primarily take the form of new restaurants. Those sorts of investing returns are rare.

When looking at the company's growth from this perspective, the $575 million Chipotle spent in the past year investing in restaurant growth is a no-brainer. Rapid restaurant growth is one factor why investor expectations are so high, and by association, why shares trade at nose-bleed price-to-earnings levels.

Underlying the company's high return on invested capital are its restaurant-level operating margins. Chipotle restaurants have some of the highest operating margins of any fast-food restaurant at 27.5%in the last quarter. And that's a 1.6 percentage point increase over the same quarter in 2014. For comparison, McDonald's company-owned restaurants generated 14.3% restaurant-level margins in the past quarter.

Store Level Mgn

Source: Company 10-Ks.

Why same restaurant sales don't matter... much
Quarter after quarter, a consistent narrative is reported in Chipotle headlines by Wall Street and the financial media. Same-restaurant sales receive the spotlight. They are the benchmark of investor expectations and what Wall Street targets.

But focusing solely on same-restaurant sales biases short-term thinking. I'm not saying same-restaurant sales are completely irrelevant, but it's not what long-term investors should hone in on.

To be fair, an increase in same-restaurant sales moves the revenue needle more in the short term than an increase in revenue from new restaurants. Not meeting near-term expectations will drive shares down.

That being said, a sustained and dramatic decline in both same-restaurant sales and margins would make investing in restaurant unit growth a poor choice (read: the spread earned on investments narrows). Such a perfect storm is unlikely to occur, though, for a very simple reason: the company has led a charge in the restaurant market that has radically changed consumer tastes toward healthier food, and consumers love its products. That fervor doesn't just dry up like the Mojave. Accordingly, same-restaurant sales are unlikely to downright nosedive over sustained periods.

Ask yourself the following
For investors looking to buy or sell shares, I suggest asking yourself two questions before taking action. First, is your investing mentality biased toward the long term? Second, do you believe Chipotle's restaurant growth will persist?

If the answer to both those questions is yes, then keying in on return on capital and restaurant-level operating margins is important and holding some shares in your portfolio is a good choice. But be patient. Headlines focusing on the wrong metrics will make it a bumpy ride.

Nathan Hamilton owns shares of Chipotle Mexican Grill. 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.