A Growth Stock Investing Lesson From Noodles & Company

Have any of you been checking out the price action in Noodles & Company since it posted its quarterly earnings figure a few days ago?

After reporting that each share of the stock earned $0.12 in the second quarter of 2014, and posted revenue figures of $99 million. Sales fell 0.6%, and the general operating margin came in at 20.4%. All in all, the business is growing at somewhere between 11% and 12%, which is a perfectly nice rate of growth for a company worth somewhere between $750 million and $1 billion.

Why, then, did the price of the stock fall so significantly? The most recent after-hours trade for the stock came in at exactly $21.00, below the $25.58 figure the stock was trading at before the earnings announcement (for a current 17.9% decline since the earnings announcement).

The company earned $0.24 per share last year. Analysts are expecting Noodles to earn somewhere around $0.40 per share this year. Pretend for a moment that this is the last trading day of 2014, and Noodles made $0.40 per share and traded at $21 on the dot. That works out to a valuation of 52.5x profits.

This is the frustrating part of unadulterated growth investing: even if you are right about the company, and you see it grow by a significant amount, the investment may still not work out as well as you’d like because you have to figure the shifting change in valuation into your calculation as well.

As Noodles & Company transition towards becoming a mid-cap company, its “permanent” valuation will eventually drift somewhere down to 30x profits. It’s very rare that you see a mature company in the food service industry do better than that—at the very least, it’s rare enough that you wouldn’t want to project a valuation higher than that when you perform your personal calculations.

In other words, as I study Noodles & Company, I think of the investment like this: Since it doesn’t pay a dividend presently, and likely won’t in the medium-term because it is using its cash profits to grow operations and open new stores (as you can see by the company’s recent sixteen-store expansion), you would need the stock to go from $21 to $42 to double your money.

If Noodles & Company traded at 30x profits at the time that happened, it would need to post profits of $1.40 per share. So if you wanted Noodles & Company to double your money by 2020, the earnings would likely need to increase almost quadruple from its current expected base of $0.40 by year-end. That very well could happen—I just don’t know—but the key takeaway to understand is that this isn’t necessarily going to be a situation where doubling profits at the business leads to a stock price doubling; the valuation shift from 50x earnings to 30x earnings means that some of the business’s growth is given away for free without you benefitting from it in any way.

Either way, the shares offer a much better deal today than they did last year. In 2013, shares hit a high of $51.97 while earning $0.24 for the year. That 216x earnings valuation explains why the business is still on pace to grow profits by 75% compared to last year, yet the price has fallen from $51 to $21 despite the growth in the business.

The problem, though, with buying companies that trade at over 50x current profits is that you need something like 15% or better growth each and every year for a solid six or seven years in a row for the investment to work out in your favor from a fundamental standpoint. When you have these inevitable “breathers” in performance, you create these situations where the stock price falls 15-20% even while the business is growing at 10-12%. The expectations baked into the stock price become so high that even moderately successful profit results end up leading to sharp, justifiable declines in the price of the stock.

With growth stock investing, you’re often investing with a negative margin of safety. When you buy stocks cheap, you tend to benefit from earnings growth plus changes in valuation as a stock transitions from trading at 15x profits to 20x profits while it is simultaneously growing. When you pay a fair price for a company, your total returns over time will mirror the growth of the company itself. With Noodles & Company, you know going in that your returns will lag the growth rate of the business because that comes with the territory of paying over 50x earnings for a stock. Even after the recent fall, you still would need Noodles & Company to grow at a 15% or so annual rate from now until 2020 to equal the performance you would get from just buying a plain old S&P 500 Index Fund. I’m not saying that will or will not happen, but it’s something that needs to figure into your calculations when you make these types of investments.