3 Restaurant Stocks With Varying Risk/Reward

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

Restaurants have long been exposed to significant competition. This has driven down both individual corporate volumes and margins. However, some companies have been able to thrive despite such an environment. Others are rapidly producing strong growth curves. And still others are in turnaround mode. Below, I review 3 companies that fit the bill of these cases.

Limited Reward, High Safety For McDonald's )...

I have been voicing my concern that McDonald's is overvalued for some time now. After management announced weak quarterly earnings, the stock has fallen 13.2% from its 52-week high. It is now valued at $86.71 per share - well under the nearly $100 price target.

At this point, I believe that McDonald's is a decent investment. It trades reasonably at a respective 16.3x and 14.6x past and forward earnings with a dividend yield of 3.6%. With limited debt, less than half of the market's volatility, and high double-digit ROA, ROE, ROI, McDonald's offers safety that few stocks can provide during this uncertain macro period. It is also forecast for 9.3% annual EPS growth over the next 5 years. I am further optimistic about the prospects of McCafe coffee in grocery aisles not only producing strong independent growth but also encouraging support of the flagship franchise business.

Assuming McDonald's meets expectations, 2016 EPS would come out to $7.78. At a multiple of 17x, this translates to a future stock value of $132.26. A 10% discount rate would put the company overvalued at a present value of $82.12. Moreover, free cash flow is relatively limited compared to the market capitalization. For the twelve trailing months ending 2Q12, the company produced $4.1 billion in free cash flow. That was virtually a nonexistent improvement off of TTM free cash flow ending 1Q10.

High Reward, Limited Safety for Wendy's (NASDAQ: WEN)

If you are looking for an unsafe but high-reward stock, I recommend considering Wendy's. It's in turnaround mode right now, coming off of $0.03 EPS over the TTM. Though analysts rate the stock a 2.8 out of 5 where "5" is a "sell," the company is still forecasted for 14.5% annual EPS growth over the next 5 years.

Moreover, the company could be an attractive takeover. It's a $1.6 billion dollar company that "feels" like it is worth much more. Indeed, the company is valued at 20% less than book value, which means that a suitor would do well buying shares for long-term EPS accretion. Activist investor Nelson Peltz has been involved in the company before, and companies that have been in turnaround mode before have a greater affinity towards corporate shakeups later on.

For the Best Risk/Reward, Go With Yum! Brands (NYSE: YUM)

Then there's Yum! Brands, which owns Pizza Hut, Taco Bell, and Chinese restaurants. While the Taco Bell segment has fared poorly in recent quarters and the market is negative on Chinese business, I believe the brand is still undervalued compared to peers. Analysts forecast that it will grow EPS by 13% annually over the next 5 years. I find this much too pessimistic in light of 13.4% annual growth over the last 5 years - a period that included the recession.

Although the stock appears expensive at 20.6x past earnings, high double-digit ROA, ROE, and ROI more than justify an optimistic outlook. UBS recently rated the company a "buy" with an $81 pice target. The stock is currently worth $69.90. The stock has outperformed McDonald's over the last 4 years, but I believe that this trend will be even more pronounced in the near future precisely because investors will move towards riskier stocks during a full recovery. This has been reinforced by Yum's CEO revising guidance upwards due to a bullish outlook on China where around 750 stores will be open by year's end.

Although revenue growth has decelerated since 2012, the general trend has been towards acceleration over the last four years. More importantly, the company has inched ahead of McDonald's in terms of growth in recent months. While McDonald's has fallen into the negative territory, Yum! has grown revenue by 9% y-o-y in the most recent quarter.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's. Motley Fool newsletter services recommend McDonald's and Yum! Brands. 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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