Investment Jungle

Loyal reader Matt W. suggested that I have a look at Starbucks Corporation (NASDAQ:SBUX).

Company Profile:

From ADVFN Financials:

Purchases and roasts high-quality whole bean coffees and sells them, along with fresh, rich-brewed coffees, Italian-style espresso beverages, cold blended beverages, coffee-related accessories and equipment primarily through its operated retail stores.

Starbucks Corp. is a large cap stock with a market capitalization of $21.58B.

Financial Analysis:

Everyone knows Starbucks and their brand. So let’s see how strong the moat is.

Checking on management’s effectiveness, we have a look at the Return on Invested Capital (ROIC). This shows an excellent trend of ever increasing ROIC over the last 10 years. It has consistently increased from a low of 8.20% into 1997 to a high of 26.10% in 2006. Management has been doing a good job.

The Return on Equity numbers confirm this trend. Last year’s ROE is 24.45%.

Moving on to the equity growth rate (also known as the book value growth rate), the moat doesn’t look as strong as it used to be. For the first 8 years, there is excellent equity growth rate in the high teens to low twenties. However, the last 2 years are of great concern. In 2005, the equity growth rate was negative 12.50%. And last year in 2006, the equity growth rate was a lowly 8.11%. Definitely a concern to a Rule #1 investor. The 5 year average, 3 year average and 1 year equity growth rate are all clearly below the 10% threshold set by Phil Town.

Strangely enough, the earnings per share growth rate has been increasing significantly over the whole period. That seems strange. Earnings per share are growing at a healthy rate, yet the book value of the company has not grown well over the same period. Warren Buffett says that these two numbers should in fact move in step with each other.

Sales growth rate has been phenomenal over the last 10 years - consistently over 20%. That brings me back to the book value growth rate. Sales have been increasing nicely and so have earnings, so what happened to the book value? Why did it not grow in step with sales and earnings?

And of course, if sales are growing, you would hope that cash flow is growing as well. We can clearly see that the cash flow growth rate has been excellent for the 10 year period.

Stock Analysis:

So far, this has been the toughest stock to put a sticker price on. Let me go through my thinking.

To come up with the EPS growth rate, I had a look at the equity growth rate. The 10 year average is 15.58%, the 5 year average is 11.02% and last year’s equity growth rate was 8.11%. My gut reaction is to normally take the lower of the 10 year or 5 year averages. This would give me an estimated EPS growth rate of 11.02%.

Looking at the analysts, they are forecasting growth of 22%! I did a double take on that one. In the last 10 year history, this stock has only twice had equity growth rates higher than 22% - back in 1998 and 2002. There is no way I could justify using a number that high. So I am going to stick with the 11.02%. That is higher than the each of the last 2 years.

And of course, this brings up the dilemma of the future P/E. Investors have definitely been willing to pay a fair amount for this company’s earnings. The 10 year average P/E is 45.53. The 5 year average P/E is 40.83. And the current P/E is 36.47. Wow. Those P/E numbers definitely seem high to me. At least the trend is in the right direction and it is coming down!

Using my Rule #1 approach, an initial guess at the P/E is twice the EPS growth rate. That would give me a estimate future P/E of 22.05. That is considerably lower than any of the historical values.

Using my EPS growth rate of 11.02% and my default P/E of 22.05, I come up with a sticker price of $12.25. That gives me an MOS of $6.12. Well, at the current price of $28.81, that means a premium of 135.21% over the sticker price!

Even looking at Warren Buffett’s theory of comparing stocks to bonds, the current 10 year US treasury bond is paying 4.95%. Starbucks current earnings yield is 2.74% indicating that for Warren Buffett, buying the 10 year bond would be the best option.

Conclusion:

Determining the sticker price was a difficult task for Starbucks. And because of that, I do not have much faith in this sticker price that I have calculated. So with that, I would pass on Starbucks. If anything, it would just be a gamble. If the analysts are right and the EPS growth rate is indeed 22%, then this stock might be worth purchasing.

But from what I have seen in the last couple of years of equity growth rate, I am not that confident that Starbucks will be able to attain that number.

Judge for yourselves. Here are my calculations. Let me know if you disagree.

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