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A reader recently sent me an email asking, "How does one invest in these recessionary times?" A question many are thinking these days.

"Carefully and with sound judgement" is an easy answer to reply, but that doesn't help much. This post will attempt to give one answer to that question.

I think that it's going to be very important to be a value investor in the coming years. A value investor buys for income and not so much for the "hope" of selling at a higher price than what he or she paid in the near future. Below is a stock chart of Starbucks (NASDAQ:SBUX) since it first became a public corporation.

On June 26, 1992, Starbucks went public and opened on its first day at 67 cents per share adjusted for stock splits. It reached a peak of 40.01 on November 16, 2006. As I write this, on April 23rd, Starbucks is 15.81 in after-hours trading.

Had you bought shares at 67 cents on the first day of trading and sold on at the peak of 40.01 nearly 14 years later, you would have had gains of around 34% annually.

But had you bought shares on November 16th, 2006 at 40.01, your investment would be down about 60% in a little over 1 and a half years.

The idea when investing in stocks is simply to buy shares businesses you would like to own at prices that are below what would be considered a fair value. I wrote a book and teach a class that's based on the book that attempts to explain how to do just that. In my book, I use a fictional story to demonstrate investment value theory. I created a story about a boy named Tom who works at a coffee shop while a teenager and eventually opens up his own coffee shop at the age of 25. He invests $100,000 of his own money to open his coffee shop. In 20 years time, after running and building it up to 5 coffee shops, he retires and closes the coffee shops. His $100,000 investment turns into $1.5 million from profits he saved in that 20 year period.

When I teach my class, I make the point that he did not have to work at the coffee shop and could have just been the investor/owner. Or, he could have just bought shares in Starbucks for example, and continued simply being the manager of the coffee shop he worked at.

So, if it was June 26, 1992 and my fictional character decided to invest his $100,000 in Starbucks stock at .67 per share, he would have bought 149,253 shares.

On November 16, 2006, a little over 14 years later, his $100,000 would have become a whopping $5.9 million! Or today, if he still held on to his shares, with the price being 15.81, $2.35 million. A fantastic investment, but a big decline in the last year and a half..

Starbucks is the kind of company you want to own. It's simply a great business and a great franchise. Over the long run, it's proven to be a terrific investment. You could have bought shares just about any time throughout the 1990s, with the exception of a few times, and if you still held them today, you would be happy with your investment returns. I know I would.

From 2003 through 2006, something happened that caused for the share price to move much higher and ultimately became overvalued. Investor expectations had become too optimistic and therefore, the stock became overvalued.

How was Tom to know that on November 16, 2006 that the price of Starbucks has become overvalued and perhaps it would have been a good time to sell his shares and not suffer a 60% decline in his investment?

That's the $64,000 question. I've created a method to make it as simple as possible to be able to help determine if something is very overvalued or very undervalued. Here is how I do it.

I simply pose the question to myself: If I had enough money to buy this entire business, would I buy it or would I instead simply put the money in the bank and earn a fixed rate of interest nearly risk free? Then I would compare how much each investment would provide me in earnings over the next 5 years. I would want to make sure, that with the risk I'd be taking with owning a business, that my estimates of what the business would earn would be substantially more than what my "near risk free" return would be, like a 5 year CD.

On January 2, 2002, is Starbucks overvalued? Fairly valued? Or undervalued? The share price is 9.76. In 2002, there were 795.05 million shares outstanding. That made the entire company cost $7.76 billion. A 5 year CD was paying about 5% in January of 2002. Putting $7.76 billion into a 5 year CD would have earned $2.143 billion over the next 5 years compounded before tax (source).

In 2002, Starbucks earned $211.39 million. The following 4 years, annual earnings would be $265.36 million, $388.88 million, $494.37 and $564.26 million for a total of $1.924 billion.

Starbucks would have made less than the CD over the 5 years. I would conclude that Starbucks in January of 2002 was not undervalued; it was not a good time to buy, but was fairly valued, and not a sell either.

In the 5th year, the CD had earned $471 million and Starbucks earned $546 million. The following 5 years, from 2007 - 2012, Starbucks could be in a position this time to earn substantially more than reinvesting into another CD. But in 2002, it's just too difficult to predict what a business might look like and how much money it can earn 5-10 years out. It's hard enough trying to guess what it'll earn in the next 5 years let alone the next quarter.

In January of 2002, Tom would have been wise to simply hold his shares in Starbucks. But on November 16, 2006, when Starbucks got to 40.01 a share, this time, things might be different. Let's see.

In 2006, there were 792.56 million shares outstanding. At 40.01 per share, the entire company would cost $31.7 billion! A 5 year CD was paying around 5.5% in 2006. Putting $31.7 billion into a CD earning 5.5% would earn $8.76 billion in interest compounded before tax over 5 years.

In the year ended September 30th, 2007, Starbucks had net income of $672.46 million or $0.87 per share. Let's assume that the forecast of earnings growth for Starbucks in November of 2006 for the following 5 years was 20% per year. Starbucks earnings could look like this:

  • 2008: $807 million
  • 2009: $968 million
  • 2010: $1,162 million
  • 2011: $1,394 million for a total of about $5 billion in net profits.

Even with very generous earnings growth estimates of 20% per year, Starbucks would earn a lot less than when compared to a CD. It now seems clear that Starbucks was overvalued at 40.01 and Tom would have been wise to sell his holdings.

What about today, in these "recessionary times?" First, let's do some math.

With a share price of 15.81 and 725.1 million shares outstanding, that makes the entire company cost $11.46 billion.

I see that I can get a 5 year CD with a yield of 4.2%. In 5 years time, with the interest compounded and before tax, I would earn $2.618 billion.

Websites like Yahoo Finance compile earnings estimates for stocks. These earnings estimates come from third party analysts like brokerage houses that cover the stock and issue their estimates.

The current earnings estimate for Starbucks for the year ending September 2008 is .97 per share or $703 million. The estimate for the annual growth in earnings over the next 5 years is 18.3%!!

If that is the case, then Starbucks would earn $5.06 billion in the next 5 years. That's almost twice as much from what the CD would earn! That sounds pretty good and makes Starbucks stock look potentially undervalued now that its down 60% from it's high just 1 and a half years ago.

Here is where the question at the top of this post becomes important. There is a reason why the share price is down as much as it is. The earnings expectations are simply too high. Just yesterday, Starbucks announced that profits for this year will be "somewhat lower" than the 87 cents a share it earned in fiscal 2007.

Earnings are going to be less than they were a year ago. If that is the case, I'm sure that the earnings growth estimates are going to be needed to be revised downward as well.

"The current economic environment is the weakest in our company's history, marked by lower home values and rising costs for energy," Chief Executive Howard Schultz said in a statement.

It is in my opinion that many of the earnings forecasts of corporations are too high and are not factoring in these "recessionary times."

Every stock should be looked at on an individual basis. Surely there are now stocks that are undervalued and may very well warrant your investment capital. But it's very critical these days to have low expectations in these coming quarters and years ahead.

The best part about the "adjustment" in share prices we're seeing is that over the coming quarters and years, many great companies may very well become great values.

Just how low will Starbucks go before it bottoms is anyone's guess. The investor who believes that it's a great value at a certain price and buys should not be concerned if the share price falls after, and may even want to buy more shares.

Disclosure: I currently have no position in Starbucks stock for either myself or clients.


Source: Starbucks: Price is What You Pay, Value is What You Get