Welcome

Shake Shack: Downward Reversion Could Be Ahead

Shake Shack (SHAK) operates a chain restaurant model that sells a range of popular fast foods.

The company has more than a hundred licensed outlets spanning across the United States and abroad. I am bearish on the stock.

Headwinds

Shake Shack CEO Randy Garutti himself claimed that the company is facing an uphill battle going into 2022, with rising input costs and uncertainty about cCOVID-19 policies causing potential wobbles.

According to Garutti, the COVID-19 pandemic policies pose a cyclical problem as workers are demanding significantly higher wages than they did pre-pandemic.

This could be problematic for a company that’s striving towards a cost-leadership strategy, especially if one considers its substantial “in-store” sales reliance.

It has to be considered that the economy moves in cycles, meaning that workers’ wage demands are likely transitory. I had a look at Shake Shack’s EBITDA growth of 120.17% and thought to myself that wage demands alone shouldn’t be a life-changing event for the company, but it could still pose short-term threats to stock valuation.

Valuation Issues

The prevalent valuation concern stems from the stock’s forecasted price-to-book value versus its current price-to-book value. If you look at the current figure, you’ll see that it’s actually level with its five-year average, which may mislead most investors.

It’s only when you consider the divergence between the return on equity (ROE) and the required rate of return that you’ll notice the arbitrage.

Shake Shack’s ROE is projected to decrease by 63% over the next year, and its cost of capital has increased by 1.54 since 2020; these data points play a role in book value because the general rule is that higher ROE growth and reduced cost of capital increase a company’s book value, and Shake Shack’s inputs are currently trending the other way around.

Furthermore, the stock’s price-to-sales ratio is already overvalued by 6.17% relative to its five-year average, but again it’s only when we consider the forward-looking metrics when the concerns arise.

Shake Shack’s forward revenue growth forecast of 17.46% is 28.92% lower than its five-year average, and by combining this with the mentioned increase in the cost of capital, we’re looking at a significantly overvalued stock.

Wall Street’s Take

Turning to Wall Street, Shake Shack has a Hold consensus rating, based on four Buys, 11 Holds, and two Sells assigned in the past three months. The average Shake Shack price target of $88.13 implies 20.6% upside potential.

Conclusion

Although Shake Shack’s income statement growth is impressive, the market has gotten ahead of itself, and the stock is overpriced. I think we’ll see downward mean reversion for the stock this year amid a slight market correction within “wage sensitive companies” category.

Download the TipRanks mobile app now  

To find good ideas for stocks trading at attractive valuations, visit TipRanks’ Best Stocks to Buy, a newly launched tool that unites all of TipRanks’ equity insights.  

Read full Disclaimer & Disclosure