Investors know that to generate alpha one must constantly seek out new opportunities and new ways of looking at the same things. Alpha can be created by capitalizing on public information that other investors can't easily process (think footnotes of an 10-k), building a better mousetrap (think a better valuation model), achieving a better understanding of how the market works (an in-depth understanding of the company and its drivers), or exploiting structural impediments of the market (think cross-methodological work and post-earnings drift).
Exploiting Structural Impediments
If you ever ask value investors what they think of technical/momentum investors, you probably won't hear a lot of support for their process. Likewise, technical/momentum investors won't be paying too much attention to valuation, dismissing it as being too subjective. That leaves a tremendous possibility for investors to generate alpha by exploiting this structural impediment, particularly given the perceived distaste that momentum investors have for value investors and vice versa. Investors are leaving alpha on the table.
Combining Value and Momentum
So, what do you think might happen if investors combine value and momentum processes successfully? The answer: alpha. That's what we strive to generate in our market-beating Best Ideas portfolio, and that's what has been shown academically to occur in a combined value-momentum process (click here for our academic white paper). Value and momentum investors, individually, are leaving a huge chunk of alpha out there ready to be exploited. And that's where we come in.
When value and momentum investors like the same stock, it explodes - think Apple (AAPL) as the most recent example. If value investors don't combine the two, they could be left holding the bag - think Radio Shack (RSH), or Hewlett Packard (HPQ). And if momentum investors don't respect valuation, they can find themselves holding Netflix (NFLX) at more than $200 per share.
Introducing the Valuentum Style of Investing
Valuentum may be our corporate name, but it is much more than that. It is a new style of investing - not value, not growth, not GARP, not momentum, but Valuentum. We combine an extensive three-stage discounted cash flow process (creating complete pro-forma financial statements) with a relative value assessment (price-to-earnings, PEG) and then add on a technical and momentum overlay to identify the best entry and exit points on the most attractive stocks on the market today.
We think earnings and free cash flow drive the valuations of stocks, and we use a tried-and-true margin of safety concept to determine which firms are undervalued. We embrace Warren Buffett and Benjamin Graham. Our technical and momentum process is also very simple and straightforward-we're not reading the stars in our technical/momentum process for our next great alpha-generator. We love to find stocks that are undervalued and that are just starting to exhibit strong technical and momentum indicators - these tend to be home runs.
We want to capture alpha, and the higher the rating on our Valuentum Buying Index (our stock-selection methodology), the higher probability a company will deliver alpha in our Best Ideas portfolio. We do not disclose our Best Ideas portfolio just anywhere- you have to visit us to see it.
Let's see if Starbucks (SBUX) is set to deliver alpha.
Our Report on Starbucks
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Starbucks earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 81.4% from 48.4% during the next two years.
The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $32, we'd take a closer look at it. Right now, however, neither the company's valuation or its score on our Valuentum Buying Index, a 5, are all that attractive.
Starbucks has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 11.3% in coming years. Total debt-to-EBITDA was 0.3 last year, while debt-to-book capitalization stood at 11.1%.
The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (GM:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Starbucks' 3-year historical return on invested capital (without goodwill) is 41.8%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Starbucks' free cash flow margin has averaged about 10.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Starbucks, cash flow from operations increased about 16% from levels registered two years ago, while capital expenditures expanded about 19% over the same time period.
Our discounted cash flow model indicates that Starbucks' shares are worth between $32.00 - $54.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $43 per share represents a price-to-earnings (P/E) ratio of about 26.6 times last year's earnings and an implied EV/EBITDA multiple of about 15.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 11.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 4.1%. Our model reflects a 5-year projected average operating margin of 15%, which is above Starbucks' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.6% for the next 15 years and 3% in perpetuity. For Starbucks, we use a 9.7% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $43 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Starbucks. We think the firm is attractive below $32 per share (the green line), but quite expensive above $54 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Starbucks' fair value at this point in time to be about $43 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Starbucks' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $55 per share in Year 3 represents our existing fair value per share of $43 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Additional disclosure: AAPL is included in our Best Ideas portfolio.