Chipotle Mexican Grill (NYSE:CMG) owns and operates more than 3,400 Mexican restaurants in five different countries. Investors have bid up its shares as much as 67 times earnings, touting the company’s growth, drive-thru sales, recession-resistant demand and balance sheet. However, at current interest rates, Chipotle’s valuation is a market anomaly. The yield on government bonds far exceeds Chipotle’s earnings yield, even in the distant future. Therefore, I am bearish on Chipotle stock.
Why Chipotle’s Valuation Makes No Sense
Warren Buffett once said, “Interest rates are linked to asset prices…like gravity is to the apple.” They power everything in the economic universe.
So what did Buffett mean? Well, in finance there is something called the “risk-free rate”. The principle is simple: If you can get 5% on a risk-free asset like a U.S. government bond, that should be the minimum rate of return required for a riskier, less safe asset like a stock. Additionally, you should have a “risk premium” that compensates for the additional risk.
Over the past 150 years, the 10-year Treasury yield has averaged about 5%, which is slightly higher than today. During the same period, the S&P 500’s median P/E ratio was 15x, delivering an earnings yield plus growth of 6.66%. This translated into compound annual returns of about 9.2% for the S&P 500 (over 150 years), meaning the average risk premium on stocks over that period was about 4.2%. .
The problem is that Chipotle has the opposite of a risk premium, which makes it look extremely overvalued. For example, on analyst earnings estimates, Chipotle has forward P/E ratios of 57x in 2024, 48x in 2025, 40x in 2026, 33x in 2027, and 28x in 2028. This translates to earnings yields of 1 .75%, 2.08%, 2.50. %, 3.03% and 3.57%. These earnings yields are a far cry from the 5.21% you can get on a one-year Treasury bond or the 4.59% you can get on a five-year Treasury bond.
Even if Chipotle meets analysts’ high growth expectations (and I don’t believe it will) and then trades at a 30x P/E ratio to its 2028 earnings, you’ll get a total return of less than 2% per year. , which results in a negative equity risk premium. This is a market anomaly. But, as Buffett said, gravity should eventually take over.
If the market decides to revalue Chipotle at a lower P/E ratio, say 35x on current earnings (offering an earnings yield plus growth of 2.86%), the stock price would fall almost 50%. A P/E ratio of 35x may seem low right now, but it’s still significantly higher than Starbucks (NYSE:SBUX) and McDonald’s (NYSE:MCD) currently marketed. Chipotle was trading at a P/E ratio of around 25x between 2008 and 2010, when it had a much greater growth opportunity ahead.
Chipotle’s growth will slow
Chipotle’s profits have grown at a breakneck pace over the past five years. From 2018 to 2023, the company’s EPS grew at a compound annual rate of 47.7%. This is partly due to the company’s improved return on assets. In other words, Chipotle was under-profit in 2018, with a return on assets of just 7.79%.
Meanwhile, companies with similar business models, like McDonald’s and Starbucks, had a return on assets of 18% in 2018 (more than double Chipotle’s return). Chipotle’s poor returns between 2016 and 2020 were likely due to foodborne illness issues and legal issues that tarnished its reputation and hurt its bottom line. However, Chipotle’s customers returned in large numbers and the company improved returns through its loyalty program, expansion and drive-thru services.
Fast forward to 2023, and Chipotle has doubled its return on assets to 15.41%, in line with other owner-operated chains. For example, Starbucks and McDonald’s also have returns on assets between 14 and 16%, which is high compared to the historical industry average.
All of this means growth will likely slow at Chipotle. For example, Chipotle’s 10-year average EPS CAGR was well below 15.5%. I expect the company’s growth to be even lower than this rate in the future. Last year, Chipotle increased its number of restaurants by just 8%. The company also relies on buyouts, which will be ineffective at 67x winnings. Additionally, there is a risk that management will fail to deliver on its promises.
Is CMG Stock a Buy, According to Analysts?
Currently, 18 of the 26 analysts covering CMG give it a buy rating; eight give it a Hold rating, and no analysts give it a Sell rating, resulting in a Moderate Buy consensus rating. THE The average price target for Chipotle Mexican Grill stock is $3,250.58., which implies an upside potential of 3.1%. Analyst price targets range from a low of $2,700 per share to a high of $3,600 per share.
The bottom line on CMG shares
Interest rates would probably have to get closer to 0% for Chipotle’s valuation to make sense. The stock appears to have a deeply negative equity risk premium. If Chipotle’s P/E ratio fell from 67x to a more appropriate multiple of 35x based on current earnings, the stock could collapse by nearly 50%.
At the same time, I believe Chipotle’s earnings growth rate will slow in coming years to below its 10-year average of 15.5%. Its growth has been meteoric over the past five years, in part thanks to a doubling of the return on its assets. Now tied with McDonald’s and Starbucks on this metric (and historically high end), I think that tailwind has disappeared. Additionally, buybacks are likely to be ineffective at these levels, and the company’s store count only grew 8% last year.
