Mendez's  Instablog

Chipotle's over $400!(CMG) That was my first thought yesterday when I was looking for stocks that have doubled in the last two years. Chipotle has grown from low 120's back in mid 2010, to a high of 443 in April 13, 2012.

Considering the fact that CMG is a burrito fast food chain, its growth is very surprising. With a P/E ratio of over 50 it is one of the highest, if not the highest in its peer class.

Using only P/E ratio we can think that the stock is overvalued, but I prefer to use one more valuation technique before arriving to that conclusion.

I decided to do a Free Cash Flow analysis on CMGto see if it's Free Cash Flow confirms its stock price. It's a very simple analysis that is often used to see if a stock is correctly valued or not.

Step 1: Compute growth rate (g)

For this we are going to use a two-stage growth. A 5 year short term growth rate and then we assume the company will decline to a long term 5% growth rate.

Because CMG doesn't have a dividend, I'm going to use it's average ROE as a proxy for the next 5 years growth.

Average = 20%

Step 2: Computer Required Rate of Return (r)

For this I'll use the popular Capital Asset Pricing Model (CAPM).

R = Risk free rate + Beta*Market Risk Premium.

Risk free rate = 3.5% (a bit higher than the 10 year Treasury Notes rate)
Beta = 1.02
Market Risk Premium = 6.2% (obtained from Professor Damodaran's website http://pages.stern.nyu.edu/~adamodar/ )

R = .035 + 1.02*.062 = 9.82%

Step 3: Calculate Free Cash Flows

We'll be calculating now the Free Cash Flow to the Firm for the year 2011. After that we multiply it by the growth rates to get the next 5 years cash flows and the terminal value.

Cash Flows

* This value is called the terminal value, the value assuming the company will grow at the same rate forever. It is calculated as : 684,718 / r - g, were r = 9.82% and g = 5%.

Step 4: Value of equity

When we add all the Present Value of FCFF we get the value of the firm = $15,916,823.
We subtract the 2011 liabilities to get the value of the equity.

Value of firm: $15,916,823
- liabilities: 1,044,226
= Value of equity: 14,872,597

Step 5: Value of shares

Chipotle has around 31.7 millions shares outstanding. We divide the value of equity by the number of shares and we get the value of each share.

= $14,872,597 / 31,700,000 = $ 469.17 x share

Conclusion:

The free cash flow valuation is a great tool to valuate companies. Cash flow is harder to manipulate than earnings, for this reason I prefer to use this analysis instead of other comparative techniques that use earnings and other values.

From the analysis we can conclude that Chipotle is actually undervalued! Using CMG's current price of 410 (as of 4/24), the stock is 14.4% undervalued.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.