Quick-service Mediterranean restaurant chain Cava Group (CAVA 0.46%) has been an absolute winner since the stock went public last June. Shares will often cool off after the initial public offering (IPO) frenzy fades, but that hasn't happened here. The stock is up a whopping 103% already.
Early success makes it difficult to determine whether it's wise to invest while the company's market cap is still modest at $10 billion or if the hype has already squeezed all the short-term investment returns out of shares.
There's a lot to like about Cava looking years into the future. However, chasing shares here might not be the best idea. Here is why.
Why is Wall Street going nuts for Cava Group?
Cava Group is a casual dining restaurant brand that serves fresh Mediterranean food. Today, the company has 323 stores spread throughout the lower half of the United States. Cava's West Coast presence is light, and the upper half of America is virtually untouched. Having so much room for store expansion paints a straightforward picture of future growth. Cava's popular comparison is the Mexican restaurant chain Chipotle Mexican Grill, which has 3,479 stores and is still rapidly expanding.
The big question is whether consumer demand will support a similar expansion plan. Cava's management believes it will. Mediterranean food is known for being rich in healthy fats, featuring plant-based foods and lean protein. Management points to studies that indicate a Mediterranean diet will dramatically decrease the risk of early death from cardiovascular disease. Consumer interest is soaring, and the restaurant landscape for Mediterranean food is fragmented.
Cava's financials are also promising. The company generated positive free cash flow in the fiscal first quarter, ended April 21, and analysts believe the business will be profitable this year. Currently, expectations are for $0.34 per share in net income. Add it all together, and Cava is a profitable business with a long runway ahead for steady top- and bottom-line growth.
The limitations of a restaurant business
Wall Street's Cava stock craze puts a lofty valuation on the stock.
Today, Cava stock trades at just over $85 per share. Assuming the company hits analyst earnings estimates for $0.34 per share, the stock trades at a forward price to earnings ratio of 250. Investors buying shares hope rapid earnings growth will quickly whittle that valuation down.
But will it? Consider this.
Business models matter. For example, a software company can dramatically expand profit margins with revenue growth because it has a relatively fixed amount of expenses. Eventually, revenue can rapidly outgrow business expenses. That means high-octane earnings growth.
Companies like Cava and Chipotle are restaurant businesses. They have variable costs for each store they open, such as food ingredients and staff. Sure, the broader business can enjoy some efficiency as it gets bigger. For example, Cava could source ingredients for less or become more efficient in its supply chain.
However, each location's financial upside is generally limited to the amount of traffic it generates and price increases.
That's why Cava and Chipotle, two very different-sized companies, have similar restaurant-level operating margins of 25.2% and 27.5%, respectively.
Companywide earnings growth is more about incremental growth by adding stores. That can create durable long-term growth but also limit how fast earnings grow.
Cava stock is just too hot to take on
The stock's valuation becomes essential, especially when considering a business like Cava. Today, analysts believe Cava's earnings will grow by an average of 30% annually for the next three to five years. That's nothing to sneeze at, but it's nowhere close enough to justify paying more than 250 times earnings for the business.
Using the price/earnings-to-growth ratio (PEG) ratio can give investors an idea of how attractive a stock's valuation is versus its earnings growth. I generally like to buy stocks with PEG ratios of 1.5 or less. Cava stock's current PEG ratio is 8.5. In other words, there's a real possibility that Cava stock either implodes from its current levels or trades sideways for many years while the business catches up, generating zero investment returns.
That makes Cava stock a potentially excellent business and a terrible investment at the same time. Investors should avoid the hype and stock until the underlying data changes significantly.
