One of my investment criteria is to avoid stocks that offer little or no margin of safety. Thus, I typically avoid stocks with lofty or unjustifiable valuations relative to the industry peers. In this article, I will run you through two of those examples:
The Wendy's Company (WEN)
Although shares of WEN have declined 8.67% over the past 12 months, at $4.74 per share, I believe the stock remains overvalued. Consensus estimates predict revenues, EBITDA, and EPS to rise by a 2-year CAGR of 3.7%, 2.5%, and 224.4%, respectively, over FY2012 and FY2013. The current price thus gives a valuation at 1.7x PEG (see below), suggesting a significant premium over the growth potential. Additionally, compared with other quick-service restaurant chains in the US (see below), WEN underperforms in many of the growth, profitability, and liquidity measures. Its lackluster FCF margin and sizable debt level only allow the company to maintain a very dangerous interest coverage ratio of 1.6x. Fortunately the firm's balance sheet remains OK as reflected by the solid current and quick ratios. Given the inferior financial performance, it would be reasonable to expect WEN trading at a discount to its peers. However, the current stock price of $4.74 actually implies a 2.7% valuation premium over both the peer average P/E and EV/EBITDA multiples, suggesting the market is likely overly optimistic on WEN.
Boston Beer Co. (SAM)
SAM has had stellar performance by returning 40.79% over the past 12 months. Analysts predict revenues and EBITDA to grow at a 2-year CAGR of 9.1% and 10.2%, respectively, over FY2012 and FY2013, and EPS to drop by 2% over the same period. At $127.01 per share, SAM trades at 1.4x PEG (see below), implying an overvalued price relative to its growth prospects. Compared with major brewers in developed markets (see below), SAM indeed has superior profitability and liquidity measures. It is the only firm in the group operates without debt financing. But to justify the current stock price of $127.01, a whopping 82.3% premium is needed to apply over the peer average P/E and EV/EBITDA multiples. The substantial premium appears to be overblown as SAM's financial conditions do not possess enough dominance to support the current valuations.
In conclusion, these two stocks' valuations are not justified by the fundamentals. Holding the stocks, investors risk a likely near-term correction if anything slightly falls short of market expectations. As such, I recommend investors, especially if you are conservative, to avoid these two stocks due to the unfavorable risk/reward profiles.
Comparable analysis tables are created by author and financial data is sourced from Yahoo Finance, Morningstar and Capital IQ.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.