Buying Opportunity or Discounted For Good Reason?

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

I'm not naïve enough to think that every time a stock drops in price that it's a buying opportunity. However, if I'm already watching a stock for an opportunity to get in, and the share price drops suddenly, I want to find out what happened. Fool.com does an excellent job of keeping up with such events, and when YUM! Brands (NYSE: YUM) shares fell by 10% near the end of November, I'm sure a lot of investors wondered the same thing I did...is this a buying opportunity?

Jeremy Bowman of Fool.com wrote up what was going on behind this 10% plunge in the stock price. He noted that the main culprit was the company's guidance for same-store sales at its Chinese locations. Since China has been a growth driver for YUM Brands, any problem with these stores is a major issue. With the company calling for a negative 4% drop in same-store sales, investors threw away the stock like stale nachos. However, Jeremy also pointed out that the company is still planning on growing its restaurant base by about 1,800 in the next year, and that this issue seemed like a “one-off event rather than a reason to change your investing thesis.” I would normally be willing to give YUM management the benefit of the doubt, but a problem in their main growth market makes me question the investment just the same. With that in mind, I want to see if this was a valuation issue or a fundamental issue.

YUM Brands for the two people in the world that don't know, owns KFC, Taco Bell, and Pizza Hut. They compete on multiple continents and with multiple restaurant concepts. I would list their major worldwide competitors as McDonald's (NYSE: MCD) and Starbucks (NASDAQ: SBUX), but one of their more well known domestic competitors is Chipotle Mexican Grill (NYSE: CMG). While each of these companies offer different challenges, they all essentially go after the same customer base. If there is a big difference, it is that both McDonald's and Starbucks tend to operate at all hours of the day, and have more diversified menus, versus both YUM Brands and Chipotle, who have more of a lunch and dinner bent to their menu items. With that being said, let's take a look at each of these competitors relative to YUM Brands and see if this drop in the stock price is a buying opportunity, or if this was a warranted sell-off based on valuation.

One way that we can compare these four companies is a look at their P/E ratios versus their expected growth rates. This is a good way to get an idea of how the market values the expected growth in each company. Where YUM Brands is concerned after its most recent drop, it sells for roughly 20.4 times forward estimates and is expected to grow at about 14.27% over the next five years. Using these figures, we find after the stock drop
, the shares carry a PEG ratio of 1.27. By comparison, McDonald's carries a PEG ratio of about 1.8, Starbucks comes in at 1.36, and Chipotle surprisingly comes in at 1.31. It's somewhat ironic that it has been said that Chipotle and YUM Brands should have similar valuations, because after both stocks have taken a hit, they trade for very similar PEG ratios. However, with YUM Brands expected to grow at 14.27% and Chipotle expected to see over 21% growth, I believe many investors would rather bet on Chipotle. As you can see, at least based on PEG, YUM Brands seems priced about right relative to its competition. Let's look at two more measures to see if this holds true using other valuation techniques.

Many value investors will look at a measure like price-to-book value to determine if a stock is attractive. This technique would argue that if you buy a good company for less than the value of the assets on its books, you may have found a good investment. Given that Warren Buffett used price-to-book to determine when he would repurchase Berkshire Hathaway shares, I'm comfortable using this measure has some value.

On a price-to-book basis, there is no nice way to say this, YUM Brands still looks expensive. According to Fool.com, YUM Brands sells for a price-to-book of about 13.82. Relatively speaking, McDonald's at 6.49, Starbucks at 7.96, and Chipotle at 6.97, look cheap. Now it could be that YUM Brands relies on less assets to generate similar profits, which would bring down the company's book value. It also could be that the value of the restaurants, land, etc. is being undervalued because of depreciation, but one would assume McDonald's could claim the same thing, and McDonald's sells for a price-to-book that is roughly half of YUM Brands. By this measure, YUM Brands still appears expensive relative to its peers.

One final test for YUM Brands is their free cash flow generation. I like to use a measure of free cash flow per dollar of sales to compare different size companies in the same industry. When it comes to free cash flow generation, YUM Brands and McDonald's have this down to a science. Both companies generated about $0.17 of free cash flow per $1 of sales. By comparison, Starbucks generated about $0.08 and Chipotle generated $0.10.

However, this isn't as simple as it first appears. Both Starbucks and Chipotle are expected to grow significantly faster than YUM Brands. This means once these two concepts begin to reach higher saturation points, their free cash flow should improve from lower expansion costs. While this would seem to argue that YUM Brands is currently undervalued, keep in mind this better free cash flow generation only matters if YUM Brands returns more of it to shareholders. Given that the company's free cash flow payout ratio of their dividend is about 21%, the potential is there, but has to be unleashed.

In summary, in two of our three tests, YUM Brands looks either fairly valued or expensive relative to its competition. When you realize this is the case after a still roughly 9% discount to the company's stock price a few months ago, it seems likely this discount was warranted. Investors looking for a quick turnaround in the stock price should be careful not to expect too much. I like YUM Brands and their business model, but the stock is right where it should be. If the company can meet analysts expectations, the stock should do fine, but any further warnings about slowing growth in China might be a signal to head for the exits.


MHenage owns shares of McDonald's Corp. The Motley Fool recommends Chipotle Mexican Grill, McDonald's Corp, and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's Corp, and Starbucks. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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