In a perennially popular posts I wrote almost exactly one year ago, I compared the growth plans for Starbucks (SBUX) to the actual accomplishments of McDonald’s (MCD - Annual Report). I wrote then:
To round off, we will assume the company can open 2,000 new stores annually in order to reach 30,000 stores in approximately 10 years. Taking just the simple McDonald’s comparison, SBUX should be able to grow its enterprise value from $29 billion today to $49 billion in 10 years. That gives an uninspiring 5.5% growth rate over those 10 years.
However, as we pointed out, SBUX is more efficient than MCD, which is reflected in a 20.8% ROE for SBUX compared to 17.7% for MCD. And MCD has debt funding which boosts its ROE. As growth slows at SBUX it too could add some debt to its mix to generate better returns for equity holders. But at any rate, the 3 per cent differential in ROE says that SBUX should be more valuable than MCD when it finally tops out. Looking up the fundamental P/E calculation on p. 192 of Analysis of Equity Investments: Valuation, we can get a good starting point. If we adjust the payout ratio to give us the same implied growth rate and required return for Starbucks as we currently have for MCD, we find that SBUX would deserve a 23.2x P/E multiple rather than the 17.3x that MCD has today. And assuming further that SBUX achieves the same debt/equity mix it could justify a $66.5 billion enterprise value. If we get there the average annual return would be more like 8.5 per cent, which is a good deal better but still may not justify the price now unless one is willing to bet that SBUX can, indeed, grow to a larger size than McDonalds (or if one assumes the average return on other investments will be less than that.)
At the time, Starbucks shares were trading at $39, and though I didn’t sell the shares I have owned for years I did take a couple of opportunities to write call options against them, pocketing a nice premium each time. Now that it is trading much lower, many investors are starting to wonder whether it is time to buy, according to Reuters.com:
Starbucks Corp. shares hit their lowest level since late 2005 on Tuesday as investor concerns about slower sales and profit growth continued to chip away at the once high-flying stock.Some on Wall Street said the free fall — including a 20 percent decline in 2007 — represents the best buying opportunity for Starbucks shares in years as sales comparisons against year-ago results get easier later this year.
One of the advantages of the long-term type of analysis I did a year ago is that unless something dramatic changes the same analysis can apply for a long time. Indeed, over that year I would argue that about the only thing that changed substantially is the share price of each company. Looking at the current enterprise value of $22 billion, and reducing the long-term horizon by a year to count for the one that passed, I calculate that the company would return 9.3% annually to the lower estimate and 13.1% annually to the higher one. Those numbers are a good deal “more like it,” and that doesn’t even take into consideration the rise in McDonald’s – which itself is now trading at $69 billion. Going the extra step and adjusting the prior estimates by the rise in McDonald’s value yields a 9-year potential valuation of $69 – $92 billion and annualized potential returns of 13.4% -17.3%. Realistically, investors should look at other scenarios as well, including the potential valuation had McDonalds lost value rather than gained.
No valuation method is perfect, and according to the Reuters article some analysts still think the price is steep.
Arun Daniel, senior consumer analyst at ING Investments, said Starbucks shares would be a better value carrying a multiple in the low 20s.
I say that’s true, and it would be an even better value with a single-digit multiple. What that type of analysis doesn’t provide, however, is a coherent reason as to why it will trade at the more attractive valuation. Perhaps it will, perhaps it won’t. With my analysis all one needs to do is ask whether a potential return of 9-17% per year justifies the risk. As for me, I’m sure not writing call options at this price.
Disclosure: Author is long Starbucks (SBUX) at time of publication.