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McDonald's (MCD) and Chipotle Mexican Grill (CMG) share prices have slid over the past twelve months, yet neither firm trades at attractive valuations. Investors shouldn't take a bite out of either stock at current valuations, especially after their recent disappointments.

McDonald's Sales Are Down

McDonald's profits suffered their first monthly decline in nine years at stores that have been open for over a year due to a drop in U.S. sales. The U.S. market accounts for about one third of McDonald's revenue. A decrease in profits by 1.1% was predicted by various analysts who track the stock closely. McDonald's stock has decreased by about 15% during 2012.

McDonald's plan is to advertise its Dollar Menu in order to attract value-conscious consumers. Moreover, new items are also to be added to the menu in 2013. McDonald's is not the only store to be using this strategy, however. Burger King Worldwide (BKW), Wendy's (WEN), and Yum Brands (YUM) are also adding new items to their respective menus. According to Telsey Advisory Group analyst Peter Saleh, McDonald's now has real challengers to contend with: "McDonald's has been taking share from everyone for many, many years." Now, competitors are:

fighting back… Burger King has been revamping their menu and advertising like crazy. They're getting more aggressive. And Taco Bell is getting more aggressive with advertising.

Sales have fallen by 2.2% in Europe and by 2.4% in Asia Pacific, Africa and the Middle East. Profits are expected to fall even further because of the holiday season.

Questioning Chipotle's Prospects

Chipotle Mexican Grill has been criticized because of its decelerating sales and earnings growth in 2012. Peter Saleh, an analyst at Telsey Advisory Group, 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 posted its slowest quarterly growth in over ten quarters. Sure, its quarterly 4.8% earnings growth would be amazing for most companies, but higher growth was priced into Chipotle shares. Lowered growth expectations sent Chipotle shares down to slightly-less-high valuations.

David Einhorn, the legendary investor behind Greenlight Capital, views the valuation of Chipotle as being too high. Mr. Einhorn recommended selling the stock short in order to profit from declining share prices, and buying them back later at a reduced price.

Mr. Einhorn's concern about valuation and continual firm's earnings growth seems justified. With the U.S. drought demolishing the corn crop, costs for dairy and meat are expected to shoot up in price in the coming months. Hence, the increased prices of corn, dairy products and meat used in Chipotle's ingredients are expected to increase. Chipotle's largest competitor, Yum Brands, has already experienced an increase in the cost of its ingredients. As a result, prices in Chipotle's menu, along with other restaurants, have risen. The question is whether consumers will object or accept these higher prices.

Net profit expectations have been tempered, even as Chipotle's guidance for future sales growth in 2013 remained unchanged. Some growth investors found a silver lining in ShopHouse, Chipotle's recently-opened an Asian-themed restaurant in Washington. ShopHouse has been successful, and there are plans to open another location with this format in Southern California.

Valuation

Even as agricultural commodity prices are rising, Chipotle trades at a high valuations. At $257 per share, investors can buy more revenues per dollar from the S&P 500 index, since it has a price-to-sales ratio of 1.30, while this stock has a much higher price to sales ratio of 3.14. Chipotle Mexican Grill shares are trading at a pricey 29.83 price-to-earnings ratio, over twice the 14.01 average of the S&P 500. The 6.33 price-to-book multiple of this stock is higher than the 2.02 S&P 500 price-to-book ratio.

Oddly, Chipotle is not alone in its high valuations. Burger King Worldwide is similarly rich, at prices near $15 per share. Burger King shares are trading at a lofty 56.91 price-to-earnings ratio, a price multiple more than four times the 14.01 P/E ratio of the S&P 500. The 4.77 price-to-book multiple of this stock is also higher than the broader market average.

Investors should also avoid Domino's Pizza (DPZ) at $40 per share. The firm's 1.39 price-to-sales ratio is in line with today's prevailing market multiples, but its 22.3 price-to-earnings ratio is much higher than the average of the S&P 500 index. Domino's Pizza's balance sheet lists a negative value for the book equity of the firm. This is a bad sign for investors, since firms with negative equity have underperformed firms with positive equity book values historically.

In contrast, the current market prices for Darden Restaurants (DRI) are fair near $50 per share. Shares offer a dividend yield of 3.73% dividend, which is much higher than the 1.82% yield of the 10-year treasury bond. Its dividend payments are likely in the future, because the company pays out 0.48 of earnings as dividends, providing considerable slack for lower earnings before dividends would need to be cut. At a 0.81 price-to-sales multiple, this stock trades at a fraction of typical market price to sales multiples. Darden shares are trading at a fair 13.80 price-to-earnings ratio, a touch below the S&P 500 average. The 3.54, the price-to-book multiple of this stock is higher than the 2.02 S&P 500 price-to-book ratio, though lower than its peers.

McDonald's is currently trading around $84 per share. At this price, shares offer a dividend yield of 3.30% dividend. Unfortunately, the firm's dividend payouts don't have tremendous room to grow, as seen in its 0.53 payout ratio. Regardless of its large dividend yield, the valuation multiples of McDonald's are less compelling. Investors can buy more revenues per dollar from the S&P 500, since this index has a price-to-sales ratio of 1.30, while this stock has a much higher 3.10 price to sales ratio. The 6.12 price-to-book multiple of this stock is higher than the 2.02 S&P 500 price-to-book ratio. McDonald's shares are trading at a fair 15.94 price-to-earnings ratio, a bit higher than the S&P 500 average. These averages are perplexing given. the company's slowdown.

Like McDonald's, Yum Brands also pays a dividend. The 1.80% dividend yield of the stock is sustainable, because the company pays out 0.34 of earnings as dividends, leaving room for earnings to fall considerably before dividends must be cut. However, its valuations are not exciting, at a price of $71 per share. Its 14.96 price-to-book multiple, 19.07 price-to-earnings ratio, and 2.42 price-to-sales ratio are typically found in today's market.

Conclusion

Investors should require lower valuation multiples from restaurant stocks. Chipotle and McDonald's are richly valued, as are many other restaurant stocks. Investors seeking exposure to the restaurant industry should investigate Darden as a buy candidate.

Source: Investors Should Demand Lower Valuation Multiples From Restaurant Stocks