You and three of your friends (all equal shares) start a chain of Mexican restau
ID: 2742689 • Letter: Y
Question
You and three of your friends (all equal shares) start a chain of Mexican restaurants (like Chipotle) that has presence only in the mountain states and in the western part of Canada. The firm is expected to register a sales of $12 million this year and you also estimate that the firm will be able to maintain a net profit margin of around 23%. A valuation expert informs you that while your firm is comparable to Chipotle (P/E 30.60) your presence is limited, your brand value is weaker, and your organization structure and manpower is relatively nascent. Therefore, your firm will suffer a 25% discount (hair-cut) in any fair valuation exercise. Find out the value of your investment in the firm.
Explanation / Answer
Chipotle Mexican Grill Inc. (NYSE: CMG) made its name in the crowded fast-food industry by boasting its use of simple, unprocessed ingredients through supporting responsible farming and advocating for food integrity. The strategy has worked well for the company when it comes to attracting customers. Any food service should be about the food quality customers receive and the service image perceived by customers. In Chipotle's case, fresh ingredients and meats from animals raised to roam free do taste better; the company's image talk is backed up by what it can do with food quality.
Investors have always had high growth expectations for Chipotle because of a seamless convergence of the company's image and the quality of the food it serves. They believed that the company could sweep the market through continued store expansions and sustainable same-store sales growth. Chipotle has largely done that with productive yearly growth and a fertile profit margin. However, expectations may have gone too far ahead of the business reality as it takes time to build a retail reach. Market valuation of Chipotle stock was at times stratospheric, making it vulnerable to volatility when the perception of the company suddenly changed.
The price to earnings ratio (PE Ratio) is the measure of the share price relative to the annual net income earned by the firm per share. PE ratio shows current investor demand for a company share. A high PE ratio generally indicates increased demand because investors anticipate earnings growth in the future. The PE ratio has units of years, which can be interpreted as the number of years of earnings to pay back purchase price.
PE ratio is often referred to as the "multiple" because it demonstrates how much an investor is willing to pay for one dollar of earnings. PE Ratios are sometimes calculated using estimations of next year's earnings per share in the denominator. When this happens, it is usually noted.
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