In part 1 of this article, I reviewed the qualitative elements of Chipotle’s (CMG) business to determine if it qualified as a consumer monopoly. My intention was not to make a buy recommendation but simply offer a way of evaluating the stock in the same manner as Warren Buffett, first by assessing the economics and staying power of the business, then by breaking down the valuation.
Chipotle vs. Uncle Sam
We’ll be assessing the valuation from three different angles. The first is only a comparative value look and doesn’t result in a firm price target. It pits the current earnings yield against the long-term treasury bond. Chipotle’s trailing 12-month earnings per share is $5.91. Dividing EPS by the current market price of $293.25 equates to an earnings yield of 2%, which falls way short of the 30-year bond yield of 4.2%. Based on analysts’ five-year earnings projections, Chipotle’s yield could grow 21% annually, but it would still be some time before it could compete with treasuries, especially in an environment where bond yields begin rising. Based on its current earnings yield, Buffett would not consider Chipotle a suitable investment.
Another way to look at valuation, and the one most likely employed by a majority of investors, simply takes the current EPS of $5.91 and multiplies it by analysts’ five-year growth projection of 21%, which equals earnings per share in the fifth year of $15.33. Multiply this by Chipotle’s current P/E of 50 to get a price target of $766.00. From current prices, this amounts to a CAGR of 21% with the price rising directly in line with earnings. But this is not the most likely scenario. Using Chipotle’s five-year average PE of 40, we arrive at a price target of 613 for a CAGR of 16%. Using Chipotle’s lowest P/E of 22.3 logged in 2009, we arrive at a price target of 342 for a CAGR of 3%.
Since Buffett seeks investments where he can virtually guarantee himself a CAGR of 15%, the very real specter of a 3% return would keep him from investing in Chipotle no matter how compelling the business. A buy price of $170 would cause him to reconsider.
The Incredible Expanding Coupon
The final way Buffett values a stock is by viewing it as an equity/bond with an expanding coupon. Looking at Chipotle in this fashion, the initial investment of $293.00 a share would be seen as a bond yielding 2% (just like the first example above), but rather than grow at the EPS growth rate, the “coupon” would increase at the rate management is growing the equity base. This is where return on equity comes in.
Chipotle’s shareholders' equity value, or book value, is $27.21. Dividing EPS of $5.91 by book value equates to a return on equity of 21.7% and this is the rate at which we can expect the equity base to grow. It follows that five years later we can expect a book value of $72.64. Multiply 72.64 by the ROE of 0.217 and you get projected earnings per share of $15.76. Multiple $15.76 by the current P/E of 40 and you obtain a five-year price target of $630.00. A PE of 22.3 brings the target down to $351.
In Chipotle’s case, since the ROE current equals the projected earnings growth, we arrive at nearly the same price targets as we did in the second example above. Unfortunately, the possibility (inevitability?) of PE compression makes it an unsuitable investment at current levels.
The price you pay determines the return you get. This is an extremely important part of Buffett’s approach to investing. Find a great business and great management, then wait until the price is right. The problem with young companies very early in their growth cycle is that they can very rarely be bought for a price that makes good business sense. While I still maintain that Chipotle is an excellent business with a bright future, it’s best bought when the consumer is once again left for dead and the stock offers reasonable upside. Now is not that time.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.