Starbucks Stock: Should You Buy Now?

I have only studied three companies in my life in which the following the following standard did not produce a good investment: Look for companies with high earnings per share growth that are supported by strong revenue growth and trading at a reasonable valuation. The only times this hasn’t worked out before involved General Electric, Wachovia, and Hostess (the first two had debt and liquidity problems, and the last had labor disputes that destroyed what should have been an excellent lifelong holding.)

Usually, high revenue growth is a sign of a business in good health. Earnings per share growth without revenue growth is likely a result of management strategy, ranging from stock buybacks to cost cuts to productivity gains. And revenue growth without earnings per share growth is likely a signal of share dilution (that’s the problem with Amazon and Facebook right now; the financial news media are often reporting the non-GAAP earnings that are spoon-fed to them by the companies without realizing that GAAP earnings are much messier because of the stock grants that dilute the existing shareholders.)

Starbucks has excellent revenue and earnings growth metrics: Over the past ten years, revenues have grown by 12% annually and earnings per share have grown by over 17% annually. For every dollar that Starbucks retains for itself (e.g. doesn’t pay in dividends), it earns returns of 22.5%. That is why profits are going through the roof—it is able to benefit from lower coffee prices while simultaneously charging more for coffee products each year.

This is not a simple feat. J.M. Smucker, one of the most powerful dozen food companies in the world, recently announced that it is lowering the price of its coffee products within the next three months (it owns the Folgers, Millstone, Kava, and Café Bustelo brands. It also licenses Dunkin Donuts coffee that gets sold in retail stores. Smucker already has its prices low—over 30% of its products are sold through Wal-Mart—and it still felt a need to fight for market share and stimulate revenue growth by lowering prices.

Starbucks does not have this problem. Not only does the company benefit from higher prices as coffee beans get cheaper, but it also responds to cheaper input costs by raising the prices of its goods. During the last quarterly conference call, Starbucks indicated that it would be raising prices by $0.05 to $.20 within the next three month (this comes after raising prices by the same amount during the January through March period.)

Over all, this amounts to a 6.5% increase in the price of Starbucks items this year. Existing stores report growth of 7% annualized, meaning that Starbucks experiences modestly higher foot traffic in response to its higher prices (the important thing is that foot traffic grows while prices get hiked by a decent amount. This is much better than a place like Procter & Gamble, which experiences a decline in sales in response to raising prices, and to a lesser extent, McDonald’s goes through the same thing when it tries to raise the price of items on the dollar menu.)

The rest of the growth at Starbucks comes from a rising store count; it is rolling out 500-600 new stores across the world each year. It still only has 11,000 stores worldwide. People think it has become saturated and has little room to grow, and that may be true, but a comparison to McDonald’s may be helpful. McDonald’s has business operations in 186 countries. Starbucks currently conducts business in 65 countries. The story of growth may not be over yet.

The difficulty is figuring out the upper boundaries of a fair price to pay for that growth. If you were sizing up Starbucks five, six, or seven years ago, you could have purchased the stock between 18x and 21x earnings. Each of those valuations fall within the purview of “reasonable valuation.” As you cross 25x earnings, I lose interest because P/E compression will eat off some of your returns and will double the punishment if your projections of future growth come in lower than expected (not only do you have to deal with the lower growth, but you have to deal with the lower P/E ratio as well.)

Starbucks, meanwhile, is on target to make $1.60 in profit this year. The current price of the stock is $54 per share. That is a P/E ratio of 33. That is problematic for “growth at a reasonable price” investors. Let’s say that between 2015 and 2022, Starbucks doubles its profits to $3.20 per share. Let’s also assume that the P/E ratio goes from 33x earnings to 20x earnings. That would imply a price of $64 per share. It’s already at $54 per share now. That means a cumulative 18% return, plus the 1% dividend you get to collect each year along the way.

The price is too high to warrant excellent returns from this price point. That doesn’t mean the analysis of Starbucks is wasted. It’s great to have it in the back of your mind during the next 20% or greater decline in the S&P 500 because it is exactly the kind of stock you want to buy-and-hold for a very long period of time when you can get a good deal on it. The only time it doesn’t work out is if you overpay by a lot during a bull market. Those are the conditions we find ourselves in now.

If you want to buy Starbucks at a good price, you will demand a 20x earnings valuation or $32 stock price. As profits grow, the appropriate valuation of the stock will also increase. But we are not near that fair point yet. That’s the hard part of living through periods of moderate overvaluation—you have to resist the urge to pretend that normal valuations for a particular stock will never return again. After all, who in the summer of 2014 thought we’d see Chevron at $94 in the summer of 2015?

There are three things necessary to be a successful investor. You need money, you need the right company, and the right price. It’s up to you to get the money. An analysis of Starbucks indicates that this is the right company. But this isn’t a case of Meatloaf where two out of three ain’t bad. You need to get all three right—and in the case of Starbucks, that means being patient until you get your price.