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Starbucks' High Should Keep You Awake at Night

The following graph plots Starbucks' gross profit margin (the brown line), and net profit margin (the red line). The significance of these fundamentals are two-fold: First of all, Starbucks' margins were reduced during the Great Recession, but still held up reasonably well. Second, we see that post-recession, Starbucks' margins have not only returned to more normal levels, but are currently higher than historically normal.

Similar to what we saw above with Starbucks' profit margins, we find a similar story with returns on assets and returns on equity. Starbucks' returns on assets and equity have returned to previous high levels. Returns on assets are currently running at 16.9%, and returns on equity is at 28.4%.

Recently, Starbucks appears to be coming more shareholder friendly. Two common metrics that can be utilized to measure a company's friendliness to its shareholders are dividends and share buybacks. The earnings and price correlated graph with dividends above shows that Starbucks started paying a dividend in September 2010. The following graph plots Starbucks' common shares outstanding since 2000 revealing that share count has fallen since 2005.

The Negative View of Starbucks' Stock Is Overvaluation

One of the most common mistakes that investors make is confusing the quality and fundamental strength of a business without regards to the company's valuation. In the case of Starbucks, what has been written thus far clearly shows this is a fundamentally strong, fast-growing and you can even say exciting company. However, what the graphics also showed was Starbucks is also currently significantly overvalued.

The consensus of 30 analysts reporting to Standard & Poor's Capital IQ forecast continued strong growth for Starbucks at 18.8% per annum. Nevertheless, and in spite of this forecast for high growth, the company's current PE ratio of 31.4 represents a very low earnings yield of only 3.3%. Utilizing the PE equals growth rate rule as a guide would indicate that Starbucks would be more fairly valued with a PE ratio of between 18 to 20.

Simply stated, I believe there are other companies with similar prospects for future growth that can be purchased at much more reasonable valuations.

Summary and Conclusions

Starbucks is a great company for sure, and I consider it a positive that the company has instituted a policy of paying and increasing the dividend each year. From a fundamental's perspective, you cannot do anything but sing the laurels of this great company that has achieved iconic status throughout the world. In other words, there is no arguing with the quality of Starbucks the company.

On the other hand, investors should recognize the stock is currently richly valued beyond what fundamentals support. Therefore, the odds are very high that intermediate future returns could either be low, or even possibly represent significant losses if the shares again revert to fair value. Caveat Emptor.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Charles (Chuck) C. Carnevale is the creator of FAST Graphs.

Chuck has over 43 years of financial experience and is the co-founder of the earnings and price correlated, powerful fundamentals analyzer software tool - FAST Graphs. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck's work stressing sound valuation has been widely published on numerous financial sites and blogs. Chuck is passionate about spreading the critical message of valuation and prudence in fundamental investing. So much so that regular readers have dubbed him "Mr. Valuation". Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

Chuck believes that correctly assessing fair value is one of the primary keys of successful stock investing, and he has dedicated his more than 40 years of experience in finance to its pursuit. Chuck agrees with legendary investors such as Warren Buffett, who recognize how important it is for investors in common stocks to possess an intelligent framework for making sound decisions that can keep emotions out of the equation. With making smart stock selections, there is no room for fear and greed.

Chuck was fortunate to learn at an early age that earnings drive long-term stock prices, and that dividends, if any, will be paid out of a company's earnings. This led him to develop FAST Graphs, the fundamentals analyzer software tool that reveals the long-term relationship between a company's earnings and its stock price and dividends over time. Chuck is most interested in the business behind the stock.
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