High Growth, High Valuation At Starbucks (SBUX)

Wow. The management team at Starbucks does not seem wedded to the public disclosure policy of “promise low, deliver high.”

At an investor’s conference in New York today, Starbucks unveiled very ambitious five-year plans for their investors.

They called for: 10% annual revenue growth, 15-20% earnings per share growth, and 5-8% same store sales growth.

It anticipates high revenue growth from its plans to open 5,000 stores in China between now and 2021, and it foresees extremely high earnings growth of nearly 20% because the coffee giant sees a total market of 1,000 “Reserve” locations across the United States where it can generate obscene profit margins by selling $10 coffee.

The catch is that everyone in the investor community is aware that Starbucks has grown earnings by 17% annually over the past ten years and continues on its present pace. At its current market cap of $85 billion, Starbucks (SBUX) stock is trading at over 30x earnings.

It’s about at that size where a terminal valuation of 20x earnings is fitting, or soon will be appropriate. Broadly, you are going to need to see the valuation compress by about a third of the long run. The implication for investors looking out over the next five to ten years is that total returns will likely lag earnings per share growth by about three to five points.

If Starbucks grows earnings at 15%, you’ll be getting 10-12% annual returns. If it grows at 20%, you’ll be getting 15% to 17% returns. But if you get only 10% earnings growth, you’ll be looking at 5% to 7% annual returns.

Prospective investors need about 10% annual earnings growth from Starbucks for total returns to at least match what you can get from the S&P 500 over the next decade.

Are the estimates from Starbucks management realistic? I think so. My basis for agreement is that Starbucks has seen annual traffic growth of 8.5% from its existing stores over the past five years, and more recently, has seen existing stores grow traffic volume by 7.5% this year after a 5% price hike. When I evaluate business quality, that is one of the friction points I give close attention: What happens when the business tries to raise prices? At Starbucks, the answer is that more people come in and purchase caffeine-fueled drinks.

I am agnostic, though I slightly disfavor, Starbucks as a stock purchase at this time. If you are super long-term, you can probably earn double-digit returns even buying at this valuation. However, I am aware of the irrationality that existed during the last recession in 2008-2009 that dragged the stock price down from $20 to $4 (not a typo). If Starbucks has a bumpy year of only 4% to 6% earnings growth, I’d expect the valuation to come down quickly. When you’re seven years removed from a recession, investors tend to price growth stocks to perfection.

Out of the 503 corporations in the S&P 500, I doubt you could come up with two dozen that have better growth characteristics than Starbucks. But there is a premium there, perhaps around 30%, that is going to have get burned off along the way. I’d rather take the chance of missing out on growth that arises from a 30x earnings starting point, but I am also in agreement with those who believe that Starbucks will outpace the S&P 500 from here.

There is where it is nice to already hold the stock tucked away in your portfolio somewhere. You can just sit back and watch compounding take place without having to endure the schizophrenic evaluation that prospective investors must now go through when weighing the future for Starbucks shares at a high level of $58.