If there’s a good historical blueprint for Starbucks stock then it is McDonald’s from the height of the Nifty Fifty craze. By the end of 1972 shares in the Golden Arches were changing hands for around 85x annual earnings. Nominally that is a huge figure to pay for any stock, but the caveat was that they had also had a massive runway for growth both domestically and internationally.
As it turns out over the following forty-four years annual returns still managed to come in at about 11.50% a year despite investors paying such a seemingly huge value premium to own shares of the business. It would’ve been a rough ride in the early years (the bear market of 1973-74 in particular) but the stock has still generated great returns. That’s basically a testament to how a combination of the capital light business model, valuable real estate and cultivating a global brand has driven massive growth of high quality earnings over the years.
Although the business model is different the Starbucks growth story has been just as crazy. For example, at this point in 2000 the shares were trading at a split-adjusted share price of $6.10. Over the course of that financial year the company generated $2.17 billion in net revenue of which $150 million ended up as bottom line net income (adjusted for non-recurring charges). In per-share figures that worked out to $1.40 and $0.097 respectively.
Imagine buying Starbucks stock at that point – the $0.097 per share in net income values it at a P/E ratio of just over 60x earnings. When you’re looking at a nominally high value like that you’ve got to sit down with a pen & paper or Excel to work out the numbers, even when your dealing with a “growth stock”. The first thing is to work out a time frame (even if it’s a buy-and-hold forever type thing). The second is what the time frame means in terms of returns.
To see what I mean by that let’s work through the though process of an investor back then. Imagine they have a time view of exactly sixteen years (just to bring us up to the present day). To be on the conservative side of things they assume that growth will have slowed significantly by then and so the stock would warrant a P/E ratio of 20x earnings rather than the 60x earnings it is at when they buy-in. Furthermore they’d like to see average compounded returns of 10% a year (excluding dividends).
Assuming my sums are correct that would have implied a stock price of $27.55 today which, at 20x earnings, would have equated to earnings-per-share of $1.37 for this year. That works out as compounded annual growth of 18%. In reality Starbucks has managed 20.45%. In addition you got to enjoy the fact that the earnings multiple has ended up at around 30x earnings rather than the initial forecast of 20x earnings because of its high rate of earnings growth.
- Overall if you had invested $10,000 in Starbucks stock at this point in 2000 it would currently be worth $106,000 (assuming dividends were accumulated). That’s equivalent to compounded annual returns of 15.90%.
Basically the returns have crushed it because business growth has come in better than anyone reasonably expected. So what about the stock today? As you’d expect from an earnings quality perspective Starbucks is an excellent business. They carry huge amounts of customer loyalty which enable them to enjoy an uncanny degree of pricing power. You can see this intuitively just from how expensive their coffees are compared to rivals, yet it doesn’t affect their traffic one bit. Likewise even when coffee prices were declining the company was able to get away with raising prices on their beverages. That’s pretty much all down to brand and customer loyalty. For whatever reasons folks consciously choose the experience of Starbucks over their rivals.
The upshot is almost insane levels of profitability. For every $5.00 spent by consumers at a Starbucks store over $0.50 ends up as bottom line profits for shareholders to enjoy as dividends, share buybacks, to finance growth and/or pay down debt. Return on invested capital for example has averaged around 30% over the past five years.
Given all that you could probably reasonably assume that will stay intact over the next decade. Remember this isn’t like a McDonald’s which is pretty ubiquitous in comparison. You don’t go to their for the experience, you go because it’s convenient (including excellent real estate locations) and they’ve done a great job marketing the brand. Starbucks on the other hand doesn’t operate under franchise for that reason; it’s as much about the experience as anything. Given that demand for Starbucks coffee is obviously quite high (as is the earnings quality) you’d probably be willing to assume that they will still be around in say fifteen years time.
The other question then is future growth with respect to the current share price. As it stands the stock is trading at around $57.50 on 2016 earnings of $1.90 per-share. That’s equivalent to a prior year P/E ratio of 30x earnings. How might a hypothetical fifteen year investment play out from those levels?
Let’s stick a future P/E ratio of 17 on the stock, and we’ll also assume that we’re looking for 8% annual returns excluding dividends. If you crunch the numbers on that it would imply a future stock price of $182 out in 2031, which on a P/E ratio of 17x prior year earnings would mean earnings-per-share of $10.75. In other words earnings would have to grow by a compounded average of 12.25% annually over the next decade-and-a-half.
Now when you compare it to the last fifteen years that doesn’t actually look too much of a stretch. Remember that since the end of 2000 the store count has gone from 3,500 to over 25,000 and earnings-per-share have risen by 20.45% compounded annually. Given that they’re currently operating in just over seventy countries you’d bet that there’s still plenty of room for growth. My guess is it’s currently on the more expensive side of fair value.
To bring up the McDonald’s comparison again you’re currently looking at about 36,500 stores globally in approximately 120 countries. Speaking of which, the situation with Starbucks stock right now also has shades of the situation that McDonald’s shares were in at the turn of the century. At the start of 2000 investors were paying the same price – roughly 30x annual profits – to own McDonald’s stock with its history of great growth and shareholder returns. Now in the end the returns to date have actually been pretty good – 9.4% compounded annually in case you’re wondering – but that didn’t stop a heap of volatility that occurred in-between, including seeing your capital lose almost 70% of it value at one point. I’m not saying the same thing will occur with Starbucks stock but its worth bearing in mind when you have that kind of blue chip growth stock with a nominally high P/E ratio.