Chipotle Mexican Grill (NYSE: CMG) has been a fantastic investment for its shareholders. The stock has skyrocketed 331% in the past five years. And during the roughly first six months of 2024, it has jumped 37%. The S&P 500 doesn't hold a candle to this superb performance.
Optimism is high for this company, to say the least. Chipotle continues reporting strong revenue and earnings growth while its store base keeps expanding with each passing quarter. Investors might struggle to find any faults with the business.
However, I see one major downside risk to the Chipotle story. Let's take a closer look at this top restaurant stock .
A risk hiding in plain sight
Since Chipotle shares have done so remarkably well, they now trade at an extremely expensive valuation. If you wanted to add the business to your portfolio, you'd be forced to pay a price-to-earnings (P/E) ratio of 66.9. The stock is priced for perfection, in my opinion, providing no margin of safety.
The S&P 500 trades at a P/E multiple of 24. And the tech-heavy Nasdaq 100 index trades at a P/E ratio of 31.9. Even within its industry, Chipotle is expensive. The stocks of leading restaurant chains Domino's Pizza (P/E of 33.6) and Starbucks (P/E of 21.5) can be bought for a much lower P/E multiple than the Tex-Mex joint.
Of course, that valuation might be justified if the growth potential was strong. Management sees a long runway to double the store base in North America . And over the next three years, earnings per share are projected to rise at a compound annual rate of 21.1%. This is a slowdown from previous years, but it's still encouraging.
Even so, the PEG ratio sits at 2.5. Anything below 1 can indicate an undervalued stock. Chipotle is well above this, meaning its still impressive prospects aren't enough to make up for the stock's expensive price tag.
While the valuation is what I believe to be the most pressing concern for prospective investors, there are other risks to be mindful of. For starters, the restaurant sector is arguably the most competitive market out there. There are no barriers to entry and consumers have no switching costs. This means Chipotle will have to remain on top of its game to drive meaningful growth in the years ahead.
Moreover, another Black Swan event , such as a health scare like the E. coli crisis in 2015, could happen. This is always a risk with any business that sources, handles, prepares, and serves food to the general public.
A top-tier company
All else equal, the ideal situation is to buy shares in a business when the valuation is lower. This adds more upside over the long term. Investors might hesitate to buy shares in Chipotle because it looks expensive today. However, I can understand why some would simply look past the stock's sky-high P/E ratio.
That's because there's no doubt that Chipotle is a high-quality company. The business absolutely shines when you consider the disruptive developments that happened in the past few years. The pandemic forced restaurants to temporarily close down. Then there were supply chain issues, followed by inflationary pressures and higher interest rates. Now, people are worried about the possibility of a recession.
Chipotle has hummed along. Between 2019 and 2023, revenue rose at a compound annual rate of 15.3%. What's remarkable is that even though 2020 was the worst year for growth, sales were still up 7.1% that year. And thanks to expanding margins, Chipotle's profitability is much better today than it was in 2019.
This has proven to be a resilient company. But investors need to always be mindful of the price they are willing to pay for a stock. If you're fine with the valuation, then it makes sense to buy. But if you're like me, the best course of action is to wait patiently until the P/E multiple drops significantly.
Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Chipotle Mexican Grill, Domino's Pizza, and Starbucks. The Motley Fool has a disclosure policy .
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