By Stockpickr Staff Columnist Peter Winkler

Recently, Hershey (HSY) disclosed to the public that its profit will take a hit as a result of rising prices for cocoa and corn sweeteners. The chocolate giant, which makes chocolate bars and Reese's Cups, among other items, announced that it would increase prices by 10% in an effort to compensate for this spike in underlying commodity prices. And despite this, the company announced that its 2008 and 2009 sales and profit targets would still come in at the lower end of street expectations.

On that news, Hershey stock took a hit.

With that in mind, I decided to take a quick look at another stable chocolate company, which is likely to see the same headwinds that Hershey is currently facing: Tootsie Roll (TR),

Everyone knows these guys -- the company has been in business since the early 1800s. However, by all accounts and valuation metrics, Tootsie is poised to follow in Hershey’s footsteps.

Tootsie Roll is also extremely overvalued, trading with a forward P/E of 35, price-to-sales of 3.1 and enterprise value/EBITDA of 18.3. Just for quick comparison, Google (GOOG), the fastest-growing company in the S&P 500, is trading with a forward P/E of 20, price-to-sales of 7.8 and enterprise value/EBITDA of 19.7. For some odd reason, investors are willing to pay similar levels for the future cash flows of Tootsie Roll to those they're willing to pay for Google. This makes no sense to me.

Even more interesting is Tootsie Roll’s declining returns and earnings, which also presents some serious doubt regarding the company's current valuations. From 2002 to 2007, the following important metrics have declined: return on assets, from 9.4% to 5.5%; return on capital, from 11.3% to 6.9%; return on equity, from 12.8% to 8.1%; EBIT margin, from 24.2% to 14.2%; and gross margins, from 43.5% to 33.9%.

With rising input costs, Tootsie Roll’s margins are going to be compressed in the future. Corn prices are up 300% since 2005, sugar prices are up 60% since 2006, and crude is up 150% since 2005. Even if we get an additional 20% pullback in all commodities, which is highly unlikely, Tootsie Roll will still have trouble passing these costs on to consumers. In fact, management has decided to change the length of the Tootsie Roll product from 2 inches to 1.875 inches.

Tootsie Roll is not going to get bought out anytime soon, a possibility the longs have been hanging onto for some time now. Operating margins are 13.8% compared with Hershey’s 16.4% and Nestle's 14%. No private equity firm or corporate buyer is going value Tootsie Roll with a forward P/E of 45. Or an EV/EBITDA of 40+. These are high-growth, high-beta technology stock valuations -- not valuations for a declining-growth company with increasing input costs and declining market share.

It is quite clear, based on all valuation metrics, that Tootsie Roll is extremely overvalued.

Posted on Aug. 26, 2008