Starbucks' High Should Keep You Awake at Night

Updated from 12:43 p.m. EDT: Starbucks closed Friday at $64.69, off 53 cents, or down 0.81%.

NEW YORK ( F.A.S.T. Graphs) -- This article will evaluate Starbucks ( SBUX) the company and Starbucks the stock, based on its price to fundamentals relationships.

Before analyzing a company for investment, it's important to have a perspective on how well the business has performed. At the end of the day, if you are a true investor you are buying the business. Moreover, when you are buying the business as a passive investor, you are really buying the company's earnings power. Few companies on the planet can match the earnings record of Starbucks Corp.

The following F.A.S.T. Graphs plots Starbucks' earnings per share since 1999. The orange line on the graph represents a P/E ratio of 21.7, which is equal to Starbucks' operating earnings growth rate of 21.7% per annum.

As I will reveal later, this represents the intrinsic value of Starbucks based on the PE equals growth rate formula popularized by the iconic Peter Lynch. The only blemish on Starbucks' impeccable record of earnings growth was a 21% drop in earnings in fiscal year 2008, the Great Recession. However, this simply led to an acceleration of earnings growth in fiscal years 2009 and 2010, reestablishing Starbucks' earnings record back to its trend line norms.

Earnings Determine Market Price: The following earnings and price correlated F.A.S.T. Graphs clearly illustrates the importance of earnings. The Earnings Growth Rate Line or True Worth Line (orange line with white triangles) is correlated with the historical stock price line. On graph after graph the lines will move in tandem. If the stock price strays away from the earnings line (over or under), inevitably price will come back to its earnings justified fair value. By adding price to our plotting of earnings on Starbucks, we see this relationship between earnings and price vividly revealed.

Starbucks' stock price rose dramatically above fair value coming out of the recession of 2001 before peaking in 2006, and then rapidly returned to fair value (price touching the orange line) over the next two years as we entered the recession of 2008. This clearly validates the danger of holding or investing in a stock when it's overvalued based on fundamentals.

The next graphic adds dividends, an important component of total return, reflected in two important ways. The pink line on the graph simply plots Starbucks' dividends, which were initiated in September 2010. The green shaded area below the pink line reflects the portion of earnings (the green shaded area) that the company paid out, which is commonly referred to as the payout ratio. Here we see that Starbucks is currently paying out about a third of their earnings to shareholders in the form of dividends.

The light blue shaded area stacked on top of the orange line also depicts dividends. However, with this iteration the dividend is represented as the income component of return, in addition to the capital appreciation component. Total return is capital appreciation plus dividend income.

Long-term shareholders in Starbucks have been lavishly rewarded by the company's long-term record of excellence. For those worried about the level of the stock market, the following performance report on Starbucks associated with the above graphs clearly illustrate that the stock market had nothing to do with Starbucks' long-term returns.

A $10,000 investment in Starbucks on Dec. 31, 1998, would have grown to $92,963.94, representing an annualized rate of return of 16.6%. Add in the dividends that it has paid since the fall of 2010 of $2936.31, and the total return, capital appreciation plus dividends paid, increases to $95,900.25 for a 16.9% per annum total return.

The following graph plots the historical P/E ratio (the dark blue line) in conjunction with 10-year Treasury note interest. Notice that the current price earnings ratio has been steadily declining since it became overpriced in fiscal 2000. However, as we've come out of the great recession of 2008, Starbucks' P/E ratio has been back on the rise and currently sits at 32.

A further indication of valuation can be seen by examining a company's current P/S ratio relative to its historical P/S ratio. The current P/S ratio for Starbucks is 3.48.

The following graph illustrates that Starbucks has consistently increased its book value per share since 1998. Perhaps the important takeaway here is that book value per share (bkvlps) continued to grow right through the recession.

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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