It's hard for anyone to deny just how wonderful an investment Chipotle Mexican Grill(NYSE: CMG) has been. Its shares have catapulted higher in the last few years thanks to a strong financial performance.
The fact that Chipotle has proven to be an outstanding business that has compounded shareholder capital means that it should be on your investing radar. However, it's best to know about one key warning before buying this unstoppable restaurant stock.
Chipotle's sky-high valuation
In the past five years, Chipotle stock has soared 307%. That gain easily outpaces the S&P 500 by a wide margin, which has generated a total return of 111%. Even this year, Chipotle has done better than the broader index.
But the warning that investors should heed is Chipotle's sky-high valuation. The stock trades at a price-to-earnings (P/E) ratio of 56.3 as of Nov. 12.
To be fair, this valuation is lower than the P/E ratio of 72.6 that shares sold for at their all-time high in June this year. Some investors might view this slight pullback as a smart buying opportunity. But I don't feel this way.
Chipotle's expensive valuation means there is no margin of safety for prospective investors, in my opinion. It demonstrates just how much optimism and enthusiasm the market has for the business and its prospects. Based on Chipotle's financial performance over the past few years, that bullish perspective is understandable.
Investors should realize that a high P/E multiple creates a major hurdle to achieving strong returns. In other words, it shows that Chipotle might be priced for perfection right now. Should same-store sales and margins come in worse than the market expects in any given quarter, the shares will take a hit.
This begs the question: At what valuation is the stock a buy candidate? I'd need to see the P/E ratio get below 30 in order to get interested. I'm not sure if this will ever happen. But I'll be keeping tabs on what Chipotle's business and stock are doing, patiently waiting for the right opportunity.
Chipotle is a high-quality business
It's important to separate a stock's valuation from the underlying business. While the former isn't attractive today, the latter points to an outstanding company.
Chipotle has exhibited solid growth between the third quarters of 2019 and 2024, with revenue doubling over those past five years. This has been partly driven by robust same-store sales gains. But it has also come from a rapidly expanding store base.
Since 2019, Chipotle has opened 1,069 net new locations, many of which were built with drive-throughs, called Chipotlanes. And the company still has lots of expansion potential. The outlook calls for 7,000 stores in North America one day, which would double the current footprint.
Each Chipotle location continues to generate more sales with each passing year. Therefore, it's easy to understand why the management team is so focused on further expanding the store base, especially since they also boast a restaurant-level margin of 25.5%.
This is a highly profitable organization. Since Q3 of 2019, net income has climbed at an annualized pace of 31.5%. Chipotle is proving that it can operate exceptionally well, particularly as it scales up and better leverages its expenses to drive ongoing efficiencies.
According to Wall Street consensus analyst estimates, earnings per share are expected to rise at a compound annual rate of 18.9% between 2024 and 2026. Even though that would be a notable slowdown, it's still a positive outlook. But it doesn't justify paying the current P/E ratio.
There's no doubt that Chipotle is a high-quality enterprise. However, the valuation just isn't compelling right now. It's best to add this business to your watch list in the hopes of a sizable pullback.
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Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Chipotle Mexican Grill. The Motley Fool recommends the following options: short December 2024 $54 puts on Chipotle Mexican Grill. The Motley Fool has a disclosure policy.
