Many claim that El Pollo Loco (NASDAQ: LOCO) should have the same valuation as Chipotle (NYSE: CMG). That’s partially why El Pollo Loco has risen from $15 a few weeks ago to $34 currently, for a more than 100 percent gain.
Comparing shares of El Pollo Loco to Chipotle can be a big mistake. In fact, the El Pollo Loco bears, not the bulls, should be comparing El Pollo Loco to Chipotle to state their case.
Enterprise Value/Sales (EV/S) is a good valuation metric to measure a company's value because it takes into account the debt and sales. El Pollo Loco now has an EV/S of 4.65, compared to CMG's 6.34.
So an El Pollo Loco bull might say, if El Pollo Loco shares were to match Chipotle’s EV/S, it would have a market cap of $1.68 billion. That would put its share price at $1.68 billion/$35.86 million = $47.
However, El Pollo Loco doesn’t deserve the same EV/S as Chipotle has, because:
El Pollo Loco isn’t growing like Chipotle is, nor does El Pollo Loco have nearly the same operating margin that Chipotle has. These are the two most important factors when calculating a stock’s appropriate EV/S.
Doing The Math
The following is a comparison of the two companies' year-on-year growth rate and operating margin for the quarter that ended March 30, 2014.
Using the PEG ratio analogy, since Chipotle has four times the growth as El Pollo Loco, then El Pollo Loco’s EV/S would be 6.3/4 = 1.6. With an EV/S of 1.6, that puts El Pollo Loco’s market cap at: 1.6 x $314.7 million - $180 million = $323.5 million. That puts El Pollo Loco’s conservative fair value at $323.5 million/35.86 million = $9 per share.
However, this analogy assumes that operating margins are the same. Since Chipotle has three times the operating margin as El Pollo Loco, we could divide the EV/S by another 3.0, which would put its value at $3 per share. As El Pollo Loco grows, then its rightful EV/S should also grow, because much of its operating expenses are fixed costs. However, if its growth rate doesn’t improve, then we could see the stock trading below $10 sometime next year.
Some bulls might make the argument: “Well, you’re using last quarter’s numbers. El Pollo Loco will do much better this next quarter.”
That’s not an accurate assumption. El Pollo Loco management wanted as high of an IPO price as they could possibly get. There is no advantage to having the IPO price at $15 as opposed to $25 for example.
In a couple months all the hype will be gone, and the stock will go to its fair value regardless of how much the IPO was. That’s what happened to all the other restaurant IPOs in the past year. If El Pollo Loco expected this quarter to be a lot better, then they would’ve waited until that quarter happened before having its IPO.
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