Using the dividend discount model, I deem Starbucks to be undervalued with 25% upside to a price target of $101.
While profit margins have been lower than that of Dunkin' Brands and McDonald's, I believe the firm's earnings history and low debt levels will result in higher margins over time.
The firm shows strong solvency measures relative to its peers, with the lowest debt-to-equity ratio compared to Dunkin' Brands and McDonald's.
This article makes use of financial ratio analysis techniques along with the Dividend Discount Model equation to argue that Starbucks (NASDAQ:SBUX) is a business with good fundamentals relative to competitors Dunkin' Brands Group Inc (NASDAQ:DNKN) and McDonald's Corp (NYSE:MCD) and is significantly undervalued with a price target of $101.
Sources: Bloomberg Businessweek, CNBC, Yahoo Finance
Financial Ratio Analysis
I use the Price-Earnings to Growth Ratio (PEG) for the three companies to compare their P/E multiple to the expected growth rate over time. Conventionally, a ratio below 1 indicates that a company is undervalued; a ratio above 1 indicates it is overvalued. However, I attempt to value the company in a rather different manner in that I use the firm's current PEG ratio and compare it to the maximum ratio achieved over the last five years. The reason for this is because PEG ratios by themselves give us no indication as to the assumed underlying growth rate and thus can be misleading. For e.g., CNBC reports a forward 3-5 year EPS growth rate of 23.8% for Starbucks, but only a 15.4% growth rate for Dunkin' Brands. Therefore, all else being equal, it runs counter to expectations to argue that Dunkin' Brands is undervalued to a greater extent than Starbucks. We can see that in terms of the upside to the maximum ratio, Starbucks has an upside of 24.18%, while Dunkin' Brands only has an upside of 11.61%. Conversely, McDonald's is seen as significantly overvalued with a current PEG ratio of 8.43.
Using financial ratio analysis techniques, I decided to rank the three companies using profitability, liquidity, solvency and activity measures. On the basis of solvency and activity, the company's performance has been quite good, showing the lowest levels of long-term debt and admittedly, the company has shown less impressive profitability and liquidity measures. However, I see this as a short-term issue rather than a longer-term concern. In particular, let's compare Starbucks' earnings record to that of Dunkin' Brands'. We can see that Dunkin' Brands clearly has higher ROE and profit margin measures than Starbucks. However, when we look at earnings, Starbucks has actually shown more vibrant EPS growth of an average 23% per year, compared to Dunkin' Brands' average EPS growth of 8%. In addition, the profitability and liquidity statistics may not be telling us the whole story. One only needs to look at the vastly higher Debt/Equity ratio of 457.36 for DNKN to see that this could be a potential warning sign. It is possible that the company can only sustain high profit margins and ROE levels through taking on excessive debt loads. In my opinion, Starbucks is a better choice given its earnings track record and lower debt levels.
Dividend Discount Model
Using a discount rate of 7% (as a traditionally accepted long-term rate of return on the S&P 500), I built a dividend discount model to forecast Starbucks' dividend growth and growth in earnings on a Terminal P/E basis to forecast a target price of $101.15 for the year 2018. I forecast a 20% year-on-year increase in both Dividends per Share and Earnings per Share, and use the forward P/E ratio as the terminal P/E measure.
In conclusion, Starbucks is a company that appears to be in a good financial position with respectable debt levels compared to two of its peers. In addition, while profit margins have traditionally been lower than its competitors, its strong earnings growth make it a good GARP stock (growth at a reasonable price) and I believe that this will be reflected in stronger profitability measures over time.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.