Is Starbucks Over Caffeinated At These Levels?

Aug.21.14 | About: Starbucks Corporation (SBUX)

Summary

SBUX shares have experienced a multi-year rally that have left the company's valuation stretched.

The company's impeccable operating results aren't sustainable for the long term but are being priced in anyway.

I think shares have downside to the mid-$60s on valuation alone.

Shares of Starbucks (NASDAQ:SBUX) have been pretty flat over the past year but prior to that experienced an enormous, multi-year rally that saw a nearly continuous uptrend from $10 to $80. After settling into the $70 to $80 range, where we find shares today, the uptrend has clearly been broken. The question for investors is whether or not the valuation has become stretched at $78 or if there is room for the coffee giant to continue to create shareholder value.

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To take a stab at this I'll use a DCF-type model you can read more about here. The model uses inputs such as earnings estimates, which I've sourced from Yahoo!; dividends, which I've set at 15% growth annually; and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 6.5%. Dividends are of particular difficulty to forecast because SBUX only recently began paying one. However, I've taken a guess here that should be close enough for this analysis.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.26

$2.68

$3.16

$3.74

$4.43

$5.24

x(1+Forecasted earnings growth)

18.60%

17.90%

18.37%

18.37%

18.37%

18.37%

=Forecasted earnings per share

$2.68

$3.16

$3.74

$4.43

$5.24

$6.20

Equity Book Value Forecasts

Equity book value at beginning of year

$6.75

$8.39

$10.35

$12.72

$15.57

$18.99

Earnings per share

$2.68

$3.16

$3.74

$4.43

$5.24

$6.20

-Dividends per share

$1.04

$1.20

$1.38

$1.58

$1.82

$2.09

=Equity book value at EOY

$6.75

$8.39

$10.35

$12.72

$15.57

$18.99

$23.10

Abnormal earnings

Equity book value at begin of year

$6.75

$8.39

$10.35

$12.72

$15.57

$18.99

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

$0.61

$0.76

$0.93

$1.14

$1.40

$1.71

Forecasted EPS

$2.68

$3.16

$3.74

$4.43

$5.24

$6.20

-Normal earnings

$0.61

$0.76

$0.93

$1.14

$1.40

$1.71

=Abnormal earnings

$2.07

$2.41

$2.81

$3.28

$3.84

$4.50

Valuation

Future abnormal earnings

$2.07

$2.41

$2.81

$3.28

$3.84

$4.50

x discount factor(0.09)

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

$1.90

$2.02

$2.17

$2.33

$2.50

$2.68

Abnormal earnings in year +6

$4.50

Assumed long-term growth rate

3.00%

Value of terminal year

$74.92

Estimated share price

Sum of discounted AE over horizon

$10.92

+PV of terminal year AE

$44.67

=PV of all AE

$55.59

+Current equity book value

$6.75

=Estimated current share price

$62.34

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At first blush we can see that the model says SBUX is worth $62 right now, a far cry from the $78 shares are trading for. So what gives?

For starters, we need to understand what the model is telling us. The model computes a fair value, which is different from a traditional price target. A price target takes earnings estimates in the future and multiplies them by some earnings multiple to project a price out into a future time period. The model, by contrast, is saying that the present value of the company's earnings stream, adjusted for dividends, is $62 today. In other words, my model says SBUX is quite overvalued at the moment.

I think the root cause of the overvaluation is simply the run SBUX has had over the past five years or so. After bottoming during the crisis SBUX has done no wrong and shares have reflected that. Don't get me wrong; results have been amazing and the company deserves the success it has seen. However, that doesn't mean you can just pay any price for shares. I think shares are so expensive, in part, because investors are giving SBUX a lot of slack in terms of operating results. Investors have been conditioned over the past few years that SBUX will continue to grow into the stratosphere and that it is okay to continuously price that growth in, whether it occurs or not. This is a dangerous game to play as it only works until it doesn't. It's not that I don't believe in the company's product or management; it's that I don't believe the company can continue to post 20% earnings growth forever.

And speaking of that, if we peruse the earnings estimates analysts have placed on SBUX for the next few years, we can see there is absolutely no let up in expectations for growth. We are talking about 18% earnings growth every year simply to meet expectations and while I don't doubt that could happen again, I think a business the size of SBUX, regardless of what the business does, will have a very hard time posting earnings growth like that. And with shares, according to my analysis, already very overvalued even assuming the business hits those targets, I'm thinking investors are pricing in something like 25%+ earnings growth. That is simply not based in reality and even if it were, it's so easy for a company to miss pie-in-the-sky earnings estimates like that it leaves no margin for error.

Indeed, the company is trading for 25 times next year's earnings estimates and even for a market leader like SBUX, which is expensive. I understand the fundamentals are terrific but it's just too expensive.

One area where SBUX is adding additional value to shareholders is its dividend. The company initiated its dividend a few years ago and since that time, the dividend has grown enormously. I forecast 15% growth in the dividend per year in my model but I think there could be upside to that number. In fact, I think we could see close to 20% growth, making SBUX more of a dividend growth story than a growth stock, as it has been in the recent past. I love when companies return cash to shareholders and SBUX has begun doing that as it has reached a more mature point in its life cycle. However, this is still not a reason to overpay.

Overall SBUX is a terrific business. The company is still managed by the visionary that took SBUX from a little shop in Seattle to a worldwide behemoth and is still firing on all cylinders. I don't doubt the company will continue to grow and be successful but the fact is that shares are pricing in unrealistic expectations right now. The dividend growth story is great but it isn't enough to pay too much for shares. I like SBUX on a pullback but I want to see it at least in the $60s before getting in. At nosebleed valuations like what SBUX has right now it doesn't take much to make the stock crash and I fear that one report that doesn't blow away expectations will tank shares. It will be at that point that investors should load up on SBUX, but not at $78.

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.