5 Restaurant Stocks With High Valuations To Avoid Now

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Even after shares dropped dramatically last week, Chipotle Mexican Grill (NYSE: CMG) is trading at a high valuation. This high price anticipates future earnings growth which may not be forthcoming either based on increasing food costs or slowing sales growth. Investors should steer clear of Chipotle to avoid disappointment and share price declines.

Questioning Chipotle’s Prospects

Chipotle Mexican Grill has been criticized because of its decelerating sales and earnings growth in 2012. Telsey Advisory Group analyst Peter Saleh said, “They’re coming up against a little bit of a ceiling. They need to do something more either on advertising or new product news.” Chipotle has witnessed their slowest quarterly growth in over ten quarters. Bear in mind that the quarterly 4.8% earnings growth would be amazing for most businesses, but higher growth was priced into Chipotle shares. Slowing growth expectations sent Chipotle shares down.

Greenlight Capital CEO David Einhorn sees the valuation of Chipotle as too high. He recommended selling short in order to profit the company by buying them back later at a reduced price.

Einhorn’s concern about the firm’s earnings growth seems justified. With the U.S. drought demolishing the corn crop, meat and dairy costs are expected to shoot up in price. The increased prices of corn, meat, and dairy products used in Chipotle’s ingredients are expected to increase. Chipotle’s biggest competitor, Yum! Brands (YUM) has already seen an increase in the cost of its ingredients. As a result of the increase in the cost of ingredients, menu prices in many restaurants are on the rise.

Thus, there are tempered net profit expectations even as guidance for future sales growth in 2013 remained unchanged. Some growth investors are optimistic about ShopHouse, Chipotle’s recently opened Asian-themed restaurant in Washington. ShopHouse has been a success and there are plans to open another restaurant with this format in Southern California.

Restaurants: Limited Value Menu

In the face of commodity price increases, an unfathomable valuation is implied by Chipotle’s market price of $238 per share. Investors can buy more revenues per dollar from the S&P 500 since this index has a price-to-sales ratio of 1.32 while this stock has a much higher 2.86 ratio. Chipotle shares are trading at a rich 27.62 price-to-earnings ratio, more than twice the 14.23 average of the S&P 500 index. The 5.73 price-to-book multiple of this stock is higher than the 2.07 S&P 500 price-to-book ratio.  This mid cap stock remains expensive based on valuation, even after a 29.7% drop in price over the past year.   

Oddly, Chipotle is not alone in its high valuation. Burger King Worldwide (BKW) is similarly rich at prices near $14 a share. Burger King shares are trading at a lofty 39.22 price-to-earnings ratio, a price multiple more than four times the 14.23 PE ratio of the S&P 500. The 4.53 price-to-book multiple of this stock is also higher than the 2.07 S&P 500 price-to-book ratio.

Domino's Pizza (NYSE: DPZ) is currently trading at a price of around $41 per share. The firm's 22.6 price-to-earnings ratio is much higher than the 14.23 average of the S&P 500 index. Domino's Pizza recently jumped 7% due to a strong third quarter earnings report. 

In contrast, the current market price for Darden Restaurants (NYSE: DRI) seems fair near $53.70 per share based on current valuation. Shares currently offer a dividend yield of 3.73%, which is much higher than the 1.82% yield of the 10-year treasury bond. Darden is in the process of updating its restaurants to keep in line with the shaky economy. The company reported a 3.9% increase in profits for the first fiscal quarter, primarily due to strong sales from its specialty stores like Bahama Breeze and Capital Grill, which made up for weaker sales in its core restaurants like Red Lobster and Olive Garden. Darden shares are trading at a fair 14.66 price-to-earnings ratio, in line with the S&P 500 average. Overall, Darden is attractively priced stock, based on valuation, compared to its peers.

Investors seeking dividend yields do not have many tasty options.

The current market price for Brinker International (NYSE: EAT) is fair near $33 per share based on current valuation. Brinker shares currently offer a dividend yield of 2.41%, which is also much higher than the 1.82% yield of the 10-year treasury bond. This stock trades at a high 17.56 price-to-earnings ratio. While Brinker has been revamping its core restaurants like Chili's and Maggiano's and cutting costs through the updating of its restaurant operating systems, the stock recently fell on lower than expected earnings per share of $0.37 on revenues of $683.5 million. Overall, Brinker is not compelling from a valuation standpoint.

McDonald's (NYSE: MCD) is looking somewhat pricey at $89 per share based on valuation. At this price, shares offer a dividend yield of 3.48% dividend. McDonald's shares are trading at a fair 16.63 price-to-earnings ratio, in line with the S&P 500 average. But McDonald's recently reported weaker than expected profits of $1.46 billion and earnings per share of $1.43. McDonald's cited the crippling European recession and a strong dollar overseas as reasons for the decline in earnings. I think McDonald's will continue to stumble on weak earnings in the coming quarters, primarily due to the ongoing threat of the European recession that could heavily impact its sales.

Conclusion

Investors should demand lower valuation multiples from restaurant stocks. Chipotle is richly valued as are many other restaurant stocks. Investors seeking exposure to the restaurant industry should investigate Darden as a buy candidate.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill, Darden Restaurants, and McDonald's. Motley Fool newsletter services recommend Chipotle Mexican Grill and McDonald's. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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