At $55, Has Starbucks Hit Its Growth Ceiling?

| About: Starbucks Corporation (SBUX)

Summary

Starbucks Corporation has reached my predicted target price having grown dividends and earnings at a much faster rate than anticipated.

However, I argue that investors need to see further growth in free cash flow to justify investment.

In my opinion, I would expect to see free cash flow per share of $2 or greater for 2016 to justify investment.

When I initially covered Starbucks Corporation (NASDAQ:SBUX), I had projected that on the basis of a 20% average growth in both dividends and earnings, the company would reach a target price of $101; or a price of $51 in today's terms accounting for a 2 to 1 stock split.

At the current price of $55, it is only reasonable to ask if Starbucks has hit its price ceiling. Moreover, earnings per share has grown at a much faster rate than the 20% per year I had initially projected, from $0.20 in 2014 to $1.694 at the time of writing:

The same can be said for free cash flow, which has grown from $-0.3 in 2014 to $1.709.

Given that the past two years have shown growth of a far greater magnitude than 20%, this means that Starbucks may in fact have reached its target price far earlier than expected.

Assuming a 10% discount rate (as a required rate of return and expected eventual long-term performance on the S&P 500 given a market lag since 2015), valuing Starbucks by dividends and free cash flow per share shows that we do not see any growth in target price assuming 10% growth in dividends and free cash flow:

Dividend Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected 10% dividend growth 0.72 0.79 0.87 0.96 1.05
10% discount rate 0.67 0.69 0.71 0.73 0.75
Free Cash Flow Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected 10% free cash flow growth 1.71 1.88 2.07 2.27 2.50
10% discount rate 1.55 1.55 1.55 1.55 1.55
Click to enlarge
Terminal Price to FCF Ratio (which is the current one) 32.66
Terminal Price to FCF Ratio * Estimated Year 5 Free Cash Flow 50.74
Present Value of Dividends Per Share Through to Year 5 3.5585129261
Target Price in Year 5 54.3002765624
Upside from price of $55.82 -2.72%
5-Year Annualized Rate of Return -0.54%
Click to enlarge

However, if we change the growth rate to 20%, then we see that we yield an eventual target price of $76:

Dividend Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected 20% dividend growth 0.72 0.86 1.04 1.24 1.49
10% discount rate 0.67 0.75 0.85 0.95 1.06
Free Cash Flow Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected 20% free cash flow growth 1.71 2.05 2.46 2.95 3.54
10% discount rate 1.55 1.69 1.85 2.02 2.20
Click to enlarge
Terminal Price to FCF Ratio (which is the current one) 32.66
Terminal Price to FCF Ratio * Estimated Year 5 Free Cash Flow 71.87
Present Value of Dividends Per Share Through to Year 5 4.2875322654
Target Price in Year 5 76.1529247087
Upside from price of $55.82 36.43%
5-Year Annualized Rate of Return 7.29%
Click to enlarge

In this context, given that the company would need to continue increasing free cash flow by an average 20% per annum to yield further upside, I would look for a confirmation of an FCF per share of $2 or above for 2016 to justify investment. This should indicate that the company has enough cash coming in to cover costs of expansion as well as grow its dividend base.

So, is such a rate of growth achievable for Starbucks? First of all, given that earnings and free cash flow have initially grown from negative/near negative rates, it is highly unlikely that we will see such a fast rate of growth in the coming years. However, I had pointed out in a previous article that while the company is expanding its businesses geographically into new markets such as China and Sub-Saharan Africa, a side effect of this is that costs are rising, and in many cases outpacing revenues.

In light of this, I had cautioned that investors should possibly wait to see further growth before initiating a long position in Starbucks. My advice still stands in this regard, and I would regard free cash flow as a more important metric than earnings since the former takes account of whether the company can healthily reinvest in the business and pay dividends in the long term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.