# Using Warren Buffett's Ten Points Of Light To Explains Why I Would Invest In Starbucks

Warren Buffett, being the great investor that he is, has disciples and droves of people wanting to learn his secrets. Some time ago, I read The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World's Most Famous Investor by Mary Buffett and David Clark. In reading this book, my big take away was what was called the "Ten Points of Light" that is used as a guideline to determine which companies Buffett would invest in. I have used this guideline to make some of my investment decisions and would like to provide my analysis here on Starbucks (NASDAQ:SBUX).

Before I venture into this analysis, I want to state that in the past, my articles have come under criticism using these "Ten Points of Light" so I would like to emphasize that this is a guideline and that I encourage you to also do your own due diligence and analysis when making your investing decisions.

Number 1. The Right Rate of Return on Shareholders' Equity

Over the course of the book, the underlying element that the company must have is a durable competitive advantage. In looking at Starbucks' shareholders' equity, the company has to show a consistently high rate of return on equity (ROE) - above 12%, which Buffett considers to be above average.

Net Income and Shareholders' Equity has been taken from Yahoo! Finance. Given this information, the following calculation of net income divided by shareholders' equity is done:

 Year Net Income Shareholders' Equity ROE 2010 945,600 3,674,700 .257 = 25.7% 2011 1,245,700 4,384,900 .284 = 28.4% 2012 1,383,800 5,109,000 .271 = 27.1%

*All numbers in thousands

Although the data only goes back three years, based on these results, we do see a consistent above average ROE between 2010-2012.

Score: 1-0

Number 2. The Safety Net: The Right Rate of Return on Total Capital

According to Investing Answers, the return on total capital is calculated by taking the sum of net income less dividends, then dividing that by the sum of debt plus equity. Buffett looks for a consistently high rate of return on total capital. Looking at some more quantitative data, debt was determined as the total current liabilities plus long-term debt.

 Year Net Income - Dividends Debt + Equity Return on Total Capital 2010 774,600 6,003,200 .129 = 12.9% 2011 856,200 7,010,200 .122 = 12.2% 2012 870,800 7,868,400 .111 = 11.1%

*All number in thousands

As you see based on these results, though the return on total capital is still relatively high, we see a decline between 2010 and 2012.

Score: 1-1

Number 3. The Right Historical Earnings

Buffett looks for companies that produce an annual Earnings Per Share (EPS) that historically shows a strong upward trend. Nasdaq.com has provided the following historical EPS data:

 Year EPS 2010 1.24 2011 1.62 2012 1.79

As you see, EPS has grown between 2010 and 2012.

Score: 2-1

Number 4. When Debt Makes Buffett Nervous

The book states that " ... companies with a durable competitive advantage typically have long-term debt burdens of fewer than five times current net earnings." Investopedia has given the formula for the debt-to-equity ratio as total liabilities divided by shareholders' equity.

 Year Total Liabilities Shareholders' Equity Debt-to-Equity Ratio 2010 2,711,200 3,674,700 .737 2011 2,975,500 4,384,900 .678 2012 3,110,200 5,109,000 .609

*Total liabilities and shareholders' equity in thousands

Looking back from 2010 to 2012, we see that the debt-to-equity ratio has decreased. If reading the book, this section was stated subjectively so realistically if the debt-to-equity ratio was over 1, then I'd be worried. But otherwise, I believe that this is a reasonable ratio.

Score: 3-1

Number 5. The Right Kind of Competitive Product or Service

The book says that you have to ask yourself these questions: "Is the product the kind that stores have to carry to be in business? Would the businesses that carry this kind of product be losing sales if they didn't carry this particular brand-name product?" The idea is to find a company or product that consumers are continuously in need of, not one they buy once in their lifetime.

Starbucks has dominated the coffee space hand-over-fist. In April 2003, Starbucks completed the purchase of Seattle's Best, and on December 31, 2012, Starbucks completed the purchase of Teavana, bringing Starbucks a larger entrance into the tea space.

Starbucks also has a smaller retail niche by selling their coffee in big box and mom and pop retailers as well as selling their coffees, cups, and coffee makers in their stores.

In Wikipedia's Starbucks page, the site reports that "...Starbucks is the largest coffeehouse company in the world, with 20,891 stores in 62 countries, including 13,279 in the United States, 1,324 in Canada, 989 in Japan, 851 in the People's Republic of China, 806 in the United Kingdom, 556 in South Korea, 377 in Mexico, 291 in Taiwan, 206 in the Philippines, 179 in Turkey, 171 in Thailand, and 167 in Germany..."

Ultimately, Starbucks is a proven leader in this market.

Score: 4-1

Number 6. How Organized Labor Can Hurt Your Investment

"Seldom will you find a durable-competitive-advantage company with an organized labor force."

There is currently a union in existence representing Starbucks workers. The Starbucks Workers Union was formed by the Industrial Workers of the World to organize retail employee and has members in New York City, Chicago, Grand Rapids, Cincinnati, Bloomington, and Omaha. This union was formed in 2004.

In April of 2009, the Union announced the formation of the first union of Starbucks workers in Latin America, Sindicato de Trabajadores de Starbucks Coffee Chila S.A. This branch of the union went on strike in Chile on July 7, 2011.

Given the amount of Starbucks stores throughout the world, I don't believe that the amount of geographical areas represented by this union is enough to truly hinder Starbucks' growth with collective bargaining agreements and the entire labor relations scope.

Score: 5-1

Number 7. Figuring out Whether the Product or Service Can be Priced to Keep Abreast of Inflation

"... a business with a durable competitive advantage is free to increase the prices of its products right along with inflation, without experiencing a decline in demand. That way its profits remain fat, no matter how inflated the economy goes."

As the direct retailer of their product, they can price their product as they see fit. The only exception to their pricing model is that retailers who sell the Starbucks bag coffee will include their own pricing on top of the Starbucks price.

Score: 6-1

Number 8. Perceiving the Right Operational Costs

This point considers how retained earnings is used and how much is used to maintain the durable competitive advantage. The idea is to take the amount of retained earnings by a business for a given period of time and measure its effect on the business's earning capacity.

The book gives the following example with H&R Block (NYSE:HRB):

In 1989, H&R Block, a company with a durable competitive advantage, earned \$1.16 a share. This means that all the capital the business had accumulated until the end of 1989 produced for its owners \$1.16 a share. Between the end of 1989 and the end of 1999, H&R Block paid out in dividends a total of \$9.34 a share. So [f]or that ten-year period, H&R Block had retained earnings of \$7.80 a share (\$17.14 - \$9.34 = \$7.80) to add to its equity base.

The company's per share earnings increased during this time from \$1.16 a share to \$2.56 a share. We can attribute the 1989 earnings of \$1.16 a [s]hare to all the capital invested and retained in H&R Block up to the end of 1989. We can also argue that the increase in earnings from \$1.16 a share in 1989 to \$2.56 a share in 2000 was due to H&R Block's durable competitive advantage and management's doing an excellent job of investing the \$7.80 a share in earnings that the company retained between 1989 and 1999.

If we subtract the 1989 per share earnings of \$1.16 from the 1999 per share earnings of \$2.56, the difference is \$1.40 a share. Thus we can argue that the \$7.80 a share retained between 1989 and 1999 produced \$1.40 a share in additional income for 1999, for a total return on 17.9% (\$1.40 divided by \$7.80 = 17.9%).

So let's work on Starbucks using this process. Let's start with 2010:

In 2010, Starbucks earned \$1.24 per share. This means that all capital received until 2010 produced \$1.24 per share for its owners. Between the end of 2010 and 2012, the total EPS was \$4.65 (\$1.24 in 2010 plus \$1.62 in 2011 plus \$1.79 in 2012). Of that, \$1.64 was paid out in dividends (\$0.36 in 2010 plus \$0.56 in 2011 plus \$0.72 in 2012). Therefore, for that three-year period, retained earnings were \$3.01 per share (\$4.65 total EPS - \$1.64 total dividends = \$3.01). Earnings increased during that time from \$1.24 in 2010 to \$1.79 in 2012. By subtracting the 2010 EPS of \$1.24 from the 2012 EPS of \$1.79, we get \$0.55. Therefore, the retained earnings of \$3.01 between 2010 and 2012 produced \$0.55 per share.

Score: 7-1

Number 9. Can the Company Repurchase Shares to the Investors' Advantage?

Buffett likes companies that buy back their shares- citing that with share buybacks comes price appreciation. More importantly, he likes companies that have buybacks regularly instead of occasionally.

In researching the stock buybacks for Starbucks, I have found that in 2010 one buyback of 6.3 million shares and a second authorization of 15 million shares. And in 2010, a 25 million share repurchase was also announced.

This is an example of the frequency and ability of Starbucks to buy its shares back.

(Click to enlarge)

SBUX data by YCharts

Looking at this chart, we can see that then the stock buyback hit its peak in October 2012, the price slowly started to tick upwards. While this chart won't be evidence itself that the buyback caused the upward trend, it can be read as at the very least one of the factors.

Score: 8-1

Number 10. Does the Value Added by Retained Earnings Increase the Market Value of the Company?

Warren believes that if you can purchase a company with a durable competitive advantage at the right price, the retained earnings of the business will continuously increase the underlying value of the business and the market will continuously ratchet up the price of the company's stock.

YCharts has provided the following book value data in this point of discussion and Yahoo! Finance has provided the price data.

On December 31, 2010, Starbucks had a book value of \$5.467 per share and traded at \$32.13. As of the close of business on June 30, 2013, Starbucks has a book value of \$7.644 per share and closed trading on June 28, 2013 at \$65.51. This means that the book value has increase by about 71.5% (\$5.467 divided by \$7.644) and the share price has appreciated by about 49% (\$32.12 divided by \$65.51). While this may not be the most definitive determination, this gives a good indication that this criteria has been satisfied.

Score: 9-1

Closing Thoughts

The "Ten Points of Light" are not an end-all-be-all to determine if a stock is a good investment or if Warren Buffett would invest in it. In this previous article I did about Apple (NASDAQ:AAPL), the results were not in favor of Apple according to the book, however a few days later, Buffett came out and said he wished that he had invested in Apple.

However, I do like to use this criteria not as a decisive measure, but to give me some more evidence in my analysis of a stock to decide what I would invest in. I believe this is a good company and I believe that there is a lot of growth potential for the future of Starbucks due to the existing market dominance and the future of Teavana in Starbucks' business.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SBUX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long BKCC, EWA, EWJ, HE, HTA, MO, NTE, and PFE.