The booming public equity market has been beneficial to investors this year. However, there have been some businesses that have absolutely crushed the broader indices.
Take Cava (NYSE: CAVA). The rising fast-casual restaurant chain has seen its shares skyrocket 177% in 2024 (as of Dec. 20), despite taking a breather in the past couple weeks. You just might be ready to take a bite out of this unstoppable restaurant stock.
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But take a step back first. Consider this one major warning before you even think about adding Cava to your portfolio.
Buying and holding companies for the long term is a great way to compound your wealth in the stock market. However, if you overpay for a business, then the potential to earn strong returns is diminished.
This is precisely what I view as the key risk with those looking to own Cava. As of this writing, the stock trades at a nosebleed valuation. The price-to-sales (P/S) ratio of 15.3 is an insanely high multiple. It’s worth mentioning that the stock’s gain in 2024 can almost entirely be attributed to the expanding P/S ratio, which has climbed 171% this year.
This clearly highlights just how excited the market has gotten about Cava’s prospects. It’s as if investors believe the business can do no wrong. On the one hand, this might make sense given revenue and net income jumped 39% and 165%, respectively, in its third quarter (ended Oct. 6).
But all else equal, it’s always better to pay a lower valuation for a company than a higher one. In the case of Cava, should the business report financial results that come in just slightly lower than Wall Street’s expectations, the stock could take a nosedive.
Viewed differently, Cava must continue delivering financial results that exceed already lofty expectations in order to drive the share price higher. That’s a huge ask.
It makes sense that investors might view Cava as being the next Chipotle Mexican Grill. The Tex-Mex restaurant concept has exhibited tremendous revenue growth in recent years, both from a combination of opening new locations and boosting same-store sales. Profitability is great, too, as Chipotle reported a stellar 16.9% operating margin in its Q3 (ended Sept. 30).
And perhaps more importantly, Chipotle has undoubtedly developed durable competitive strengths. Its brand presence in the restaurant sector shouldn’t be taken for granted. The company bounced back successfully following the E. coli outbreak in 2015, gaining the trust of customers once again to post superb financial performance.
Additionally, with its 3,615 stores in total, Chipotle has scale advantages that smaller chains simply don’t possess. The company can obtain better pricing on inputs like food and packaging. It has the resources to acquire favorable real estate for new locations. And Chipotle can better leverage fixed technology and marketing expenses over a much higher revenue base.
So, while Chipotle has already proven itself to be an incredibly lucrative restaurant chain, Cava is a long way from getting to this point. In fact, I think there’s a much greater than 50% chance that Cava gets nowhere near the scale of Chipotle.
But as of this writing, Chipotle shares trade at a P/S ratio of 7.8, about half of Cava’s valuation multiple. Put another way, each Chipotle location carries a market cap of $23.3 million. Each Cava store, on the other hand, is valued by the market at $38.8 million.
It’s clear that Cava’s valuation has gotten extremely stretched, which is a major risk for investors. Not only that, but it’s not close to being on the same level as Chipotle just yet.
Long-term investors who are still interested in Cava should continue monitoring the business’s progress, making sure that key financial metrics trend in the right direction. After this condition is met, it’s all about being patient and waiting for a much more attractive valuation.
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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. The Motley Fool recommends Cava Group and recommends the following options: short December 2024 $54 puts on Chipotle Mexican Grill. The Motley Fool has a disclosure policy.
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