Figuring out the difference between a pot-hole and a sinkhole is a pretty critical skill when it comes to investing in high-growth stocks, and it seems especially relevant to Chipotle Mexican Grill (NYSE:CMG). Whether slower comps later this year are just a lull or a new trend, and whether the company can maintain exceptionally high restaurant margins are two huge questions that play directly into the valuation. Given the high valuation, I can understand if investors feel that caution is the better part of valor and want to step to the side for the time being.

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The Current Quarter Was Alright, but ...
Chipotle's second quarter was not perfect, but not likely much of a factor in the significant negative reaction in the market.

Revenue rose almost 21%, but comps did disappoint. Whereas much of the Street had comps pegged at 10%, Chipotle posted an 8% growth as traffic numbers deteriorated through the quarter. Counterbalancing this was an exceptional result in restaurant-level margin; this margin grew more than three points to 29.2% - well ahead of the high teens level at McDonald's (NYSE:MCD) and low 20s at Panera (Nasdaq:PNRA).

Likewise, operating income was very healthy, growing 60% on a nearly five point expansion in operating margin.

SEE: Understanding The Income Statement

... Guidance Upset a Lot of Stomachs
The biggest issue coming out of Chipotle's quarter appears to be the significant slowdown in comps. Not only did Chipotle break a nearly two-year run of double-digit comps, but a significant pricing roll-off from this quarter and management's guidance for steady traffic growth (around 3%) suggests low-to-mid single-digit comps for the third quarter (versus 11.3% last year).

Restaurants live and die off their comps, so clearly this is a big deal for Chipotle. What's not so clear is what, exactly, it might mean.

Back in 2008, Chipotle was one of the first restaurants to see weakening comps ahead of a big macro downturn for the industry (which, with its emphasis on value pricing, helped McDonald's quite a lot). This isn't completely surprising, as Chipotle is not the cheapest QSR out there, and it would be bad news for the likes of Panera as well.

On the other hand, maybe Taco Bell's ((part of Yum! Brands (NYSE:YUM)) focus on its Cantina menu is finally starting to draw some traffic from Chipotle. Taco Bell's comps were exceptionally strong this past quarter (up 13%), and while a lot of talk has been about the success of the Dorito taco, I wouldn't be shocked if financially stressed Chipotle customers are giving the cheaper Cantina menu a try.

The Growth Potential Is Still Huge
Growth investors can still find some solace in the reality that Chipotle hasn't even come close yet to maxing out its opportunities. The United States and Canada can probably support twice the store base that the company has today, and I think the company's new Southeast Asian-themed concept (ShopHouse Southeast Asian Kitchen) could have real legs to it. Anybody who has traveled to Vietnam, Malaysia or Thailand can speak to how common, popular and tasty the noodle-based street food is there, and this could be a remarkably lucrative new business if Chipotle can coax customers into giving it a shot.

But that's not the only growth angle to Chipotle. This company is still in the building phase, and that sucks away free cash flow. As the company matures and leverages past investment, I see substantial upside to free cash flow conversion, even granting that older stores will need periodic refurbishment and current restaurant-level margins may be impossible to maintain.

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
The problem with Chipotle, apart from sentiment now, is that it takes pretty extreme projections to get to an appealing fair value. Even with the incremental free cash flow leverage scenario that I laid out, 20% compound forward free cash flow growth produces a fair value of about $325 on these shares. Put differently, Chipotle's free cash flow in 2012 has to be about 25% larger than that of Yum! Brands over the past 12 months just to be more or less fairly valued. With that sort of growth already built into expectations, I'm not inclined to regard the shares today as any sort of value.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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