When Cava Group (CAVA +3.17%) came public in June 2023, it traded at a price-to-sales ratio well above that of much larger peer Chipotle Mexican Grill (CMG 0.48%). Although that situation has since reversed, thanks largely to Cava's stock declining, investors looking at the relatively young company should still tread with caution.
Cava wanted to look good for the IPO
When a company holds an initial public offering (IPO), the goal is to get investors excited so it can sell as much stock as possible at as high a price as possible. There's nothing nefarious in that; it is what the company should be doing as it looks to raise cash to grow its business.
But there are things that investors need to watch out for when Wall Street hypes a new stock. For example, when Cava reported its first quarterly earnings as a public company, it noted that its store count had increased a massive 43% year over year.
Image source: Getty Images.
That's not a sustainable growth rate, but it probably made the restaurant's revenue growth look great on the data released when the IPO was being shopped around. The new store openings and revenue growth were likely both a part of the story being told, but investors (often myopically) focus on the top line without thinking about the factors driving it. Blind extrapolation of past trends into the future is not a good idea.
This is why it is worth pointing out that during Cava's second-quarter 2023 earnings conference call, management noted that it had "built our 2024 and 2025 pipeline to support annual unit count growth of at least 15%." That's still a solid growth rate, but it's much lower than 43%.
NYSE: CAVA
Key Data Points
What's also interesting here is how similar the Cava concept is to Chipotle. They both offer assembly-line-style personalized food preparation, just one is Tex-Mex themed and the other Mediterranean. So a comparison of the two companies makes a lot of sense, as long as you remember that Cava is a relatively tiny upstart with virtually no public track record and Chipotle is an industry giant with an impressive business history.
Some Cava investors had unrealistic expectations
Here's the problem: It is still kind of early to know whether Cava has the same growth potential as Chipotle, which is why valuing the newcomer with a price-to-sales ratio above that of Chipotle really doesn't make much sense. You'd have to go in believing that it will execute well over multiple years to grow its business just like its larger peer had done. It might happen, it might not. The uncertainty of the outcome suggests a discount is probably warranted.
CAVA PS Ratio data by YCharts
With Cava's P/S ratio now down below Chipotle's, however, what should investors think of Cava stock? The answer is probably to tread with caution for a little longer. After all, it still only has a couple of quarters as a public company under its belt. That's a really short track record to go by.
If you go back and look at the long-term history of Chipotle, the stock is up some 4,000% spread over more than a decade of business growth. In other words, you have time to watch Cava for a little bit longer to see how the company performs now that it is public -- even if it turns out to be the next Chipotle.
Cava is interesting and it looks like the concept could have a lot of growth ahead of it. So it is worth keeping on your watch list, perhaps monitoring its execution over the next year. If Cava manages its growth well (it is opening a lot of new restaurants), it might be worth an investment. But until it proves itself as a public company, betting on positive performance is probably a bit speculative at this point.
No need to rush on Cava stock
IPOs can be a hectic time for a business as it tries to look its best for the big unveiling. For investors thinking about long-term results, it is often best to err on the side of caution with young companies to see how they perform after going public. The transition can be difficult and has derailed more than one company.
You don't get a good feel for a business's ability to execute until it has reported publicly for at least a few quarters, and even then you should still tread cautiously. With Cava having IPO'd so recently, even the price drop and valuation decline probably aren't enough to justify an investment given that the growth story here could play out over decades.
