As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Chipotle's (CMG) case, we think the firm is overvalued. We think the firm's shares are worth $306 each.
For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. Our process remains consistent with the idea that a combined value and momentum portfolio outperforms that of a value, growth, and momentum portfolio, individually, and a combined growth-momentum portfolio, on average. Our white paper showcasing this phenomenon can be downloaded here. In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Chipotle posts a VBI score of 2 on our scale, reflecting our 'overvalued' DCF assessment, unattractive relative valuation versus peers, and neutral techinicals. The firm is bordering on a poor value signal and poor momentum signal, which has revealed price underperformance in future periods. We use Darden Restaurants (DRI), McDonald's (MCD), Starbucks (SBUX), and Yum! Brands (YUM) for our peer group analysis.
Our Report on Chipotle
In the spirit of transparency, our report on Chipotle and hundreds of other companies can be found here.
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Chipotle earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 49.2% from 36.9% during the next two years.
Although we don't think the firm's valuation indicates an attractive investment opportunity at this time, we'd take a closer look if the firm's share price fell below $214. The market seems to be pricing greater long-term revenue growth and profit expansion than we think is achievable.
Chipotle has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 8.8% in coming years.
We don't think the firm's valuation indicates an attractive investment opportunity at this time, and we are strongly considering re-opening up a put position in the portfolio of our Best Ideas Newsletter. The company's shares are overbought based on its money flow index. A short-term pull back in the stock price shouldn't be unexpected.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Chipotle's 3-year historical return on invested capital (without goodwill) is 32.5%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Chipotle's free cash flow margin has averaged about 10.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Chipotle, cash flow from operations increased about 58% from levels registered two years ago, while capital expenditures expanded about 29% over the same time period.
The estimated fair value of $306 per share represents a price-to-earnings (P/E) ratio of about 45.2 times last year's earnings and an implied EV/EBITDA multiple of about 21.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 17.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 19.4%. Our model reflects a 5-year projected average operating margin of 16.7%, which is above
Chipotle's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 8.5% for the next 15 years and 3% in perpetuity. For Chipotle, we use a 9.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $306 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After
all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Chipotle. We think the firm is attractive below $214 per share (the green line), but quite expensive above $398 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Chipotle's fair value at this point in time to be about $306 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Chipotle's expected equity value per share over the next three years,
assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $406 per share in Year 3 represents our existing fair value per share of $306 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from
the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.