When is it OK to pay an all-time high price for a stock you'd like to own?
That's a question that has been nagging at me for the past couple weeks -- when I noticed that a whole slew of fast food restaurants were hitting record high prices. America's love for fast food doesn't appear to be ending anytime soon -- despite a trend toward healthier and more natural foods. But nothing really explains the number of fast food stocks with not just high prices, but ridiculous valuations.
A couple weeks ago, I told you about The Billion Dollar Noodle Shop and Noodles & Co. (NASDAQ:NDLS) trading at 100x earnings. But there are many others commanding juicy valuations. There is the chicken franchise Buffalo Wild Wings (NASDAQ:BWLD) at 27x earnings and burrito shop Chipotle (NYSE:CMG) at 38x earnings. Now, these valuations aren't ridiculous. But they're a good 50%-100% above the average S&P 500 stock valuation.
When I see a sector that trades at a premium valuation, I want to know why. What justifies that rich price tag? We know that investors pay more for growing companies. So it stands to reason that high growth restaurant chains would command a premium valuation. That's simply because investors will pay a higher price today for bigger profits in the future.
But perhaps the biggest reason that investors will pay premium prices for small restaurants is due to their potential. There is a strong desire to invest in the next McDonald's (NYSE:MCD) or Starbucks (NASDAQ:SBUX) -- stocks that have been amazing long-term investments for those who got in on the ground floor.
My cardinal rule for buying any stock is to purchase only when I see an attractive value. In some ways, it's easiest to think about value in the simplest of terms. Let's assume that you're filthy rich and you've been approached by an investment banker. He suggests that you buy Noodles & Co. -- the entire company -- at its current $1.2 billion valuation. Based on current earnings, you'd wait 100 years to earn back your entire investment. Would you be willing to wait that long?
To give you a point of reference, if you were to buy a local restaurant in your town, you might pay between 4x and 6x the earnings. Of course, the reason for that premium valuation is that investors think Noodles & Co. will grow. And those earnings could grow too.
When buying a company at such a rich valuation, I know that it will have to grow like a weed for the next decade or two in order to justify a premium price. That's a big risk, but it isn't the only one. If there is even the slightest misstep or financial shortfall, bullish growth investors will rush to the sidelines. When that happens, shares of a stock can drop 20%-30% in a single day. And that creates significant volatility.
Don't get me wrong. I'm not pessimistic on the entire restaurant sector. My favorite play is one of the biggest restaurants -- McDonald's. I recommended the stock to my High Yield Wealth subscribers in early 2011 when shares traded at $75. Since then, the stock has risen 29% to $97. Plus, the company paid nearly $8 in dividends.
One of the reasons I love McDonald's is because the stock is a dividend grower. It has increased its dividend in each of the last 35 years, including a 26% jump in just the past 18 months. And my current yield -- based on the $75 purchase price -- is at 4.1%. The dividend growth and yield is crucial for income investors. But the most important thing to consider is the valuation. Shares are up considerably, but remain reasonably priced at 17x earnings. That valuation is in line with the stock's historic valuation and the stock market's average long-term valuation.
McDonald's may not have the same growth story as Noodles & Co. or other richly priced restaurant stocks. But the company's commitment to shareholders, consistent dividend growth, and reasonable valuation still make this stock a great long-term investment. After disappointing earnings yesterday, McDonald's shares are off 6% from their all-time high of $103. While most investors wish they had bought the stock years ago, the recent pullback may be a good short-term buying opportunity.
I've learned over the years that usually it's best to just buy a great company like McDonald's, rather than trying to find the next McDonald's.