3 Well-Run But Overvalued Stocks

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

You can have the most well-run company in the world. But if you ask investors to get in at a multiple that is considerably higher than that of its peers, it no longer matters. Shareholder value is dependent on the future, so high multiples are an implicit way of saying that the current investors are confident that the future will be much better than today. The problem is that, at some point, new investors can't get an attractive entry when a bar has been set too high. Below, I review three strong restaurant chains that I believe are overvalued.

Yum! Brands (NYSE: YUM) & McDonald's (NYSE: MCD): Delicious But Expensive

While Yum has the excellent diversification in China, and McDonald's has the most recognizable brand name in the fast chain business worldwide, they are both overly expensive. McDonald's trades at a respective 17.1x and 15.3x past and forward earnings, with a dividend yield of 3.4%. This compares to corresponding figures of 20.7x and 17.7x for Yum.

Like Starbucks (NASDAQ: SBUX), I feel McDonald's has already hit its apex. The days of saturating the market by opening a store on every corner are over. To fuel growth in the future, McDonald's has instead signaled an interest in selling grocery items. This was perhaps most notably suggested just a few days ago through the trademark filing with the USPTO, which will allow McDonald's to print the agency's name on ground and whole-bean coffee items.

It is important to put this into the correct context: Starbucks released its own bagged coffee around 14 years ago, which has since gone on to occupying shelf spaces of nearly all supermarkets and grocers. McDonald's, some years later, introduce McCafe, which has been a huge success and now represents a little more than one-twentieth of the business. As exciting as the possible entrance into grocery items is, the stock is already factoring in considerable optimism--indicated by how the PE multiple is above historical levels.

Similarly, Yum! has strong fundamentals, but is even pricier than McDonald's while having a lower dividend yield. Sure, the firm is forecasted for nearly 400 bps greater annual EPS growth over the next 5 years, but this comes with double the volatility. Are investors really willing to take on that risk for a company that is already more expensive on a PE basis than the S&P 500?

Yum!’s performance has generally been in-line to slightly-above consensus, but momentum is still pretty slow. The one thing I believe investors have going for them is the abnormally low bar that has been set for China. After economists saw slower-than-expected growth in the emerging country, Wall Street analysts were quick to warn their clients. The problem now is that the reaction has overblown the situation. In the short-term, China may be weaker than we expect; but, in the longer term, it has solid secular trends that are supported by a rising middle class.

Starbucks: Even More Expensive

In my view, Starbucks is one of the most overvalued stocks on the Street. Though it is a well-run company, its price tag of 27.2x is at a considerable premium to Dunkin's 24.4x, McDonald's 17.1x, and GMCR's 10.2x. If management fails to achieve the 18.5% annual EPS growth forecast set by the Street, we should see multiples start to contract. Given that the stock has a beta of 1.2, this magnifies just how much we can expect the contraction to be.

In short, I recommend avoiding the stock. McDonald's possible entry into Starbucks’ arena may put a wrench into the premium brand's ability to achieve its double-digit forecast. For years, Starbucks has struggled under the reputation of being overly expensive coffee for elusively better quality. McDonald's is well known for standardization and, ironically, quality tends to accompany this. When you order a coffee at McDonald's, you know what you are getting and look forward to it. This predictability is quality in it is own right, and, at a low prices, it's potentially worth buying over Starbucks’ bagged coffee.

Coffee prices have been very volatile in recent years, but both McDonald's and Dunkin have secured low prices. Management at Starbucks has hedged against volatility through the futures market, but this has come at the cost of reducing upside. In the third quarter, revenue grew to $0.36 per share, which was well below the $0.45 per share Street forecast. Expansion into India looks good, given the 31% third quarter growth in Asia (which now makes up 13% of the bottom-line), but, at this point, you would have to buy at elevated prices to gain exposure. Accordingly, I recommend holding out.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend McDonald's 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.If you have questions about this post or the Fool’s blog network, click here for information.

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