recent quarter ending January 2, 2022<\/span><\/strong><\/a> as the starting point, sales were $8,050 Million. Extrapolating for the entire year it equals $32,200 Million in sales for 2023. At 11.25% average net profit, Starbucks will earn about $3,622,500,000 ($3.6 Billion). Just to illustrate Starbucks’ poor performance, sales during this past quarter ending January 2, 2022 were $8,050 Million and net profit was only $816 Million; that’s a 10.13% net profit margin and the 11.25% was the expected amount. Thus, Starbucks didn’t even match the historical average; it fell short by $89.6 Million.<\/span><\/p>\nFor the purposes of the intrinsic value formula, a conservative earnings value is $3,138 Million, a reasonable expectation is $3,623 Million and for a more liberal outcome, earnings is $3,800 Million. These are the values for this element of the formula used further below.<\/span><\/p>\nRisk Factor<\/strong><\/span><\/h3>\nThe risk factor is the second element in the intrinsic value formula for earnings. This formula uses the standard discounted earnings financial function whereby earnings are discounted based on a risk factor over an extended period of time (25 to 30 years) and summed to a cumulative total current value. For those of you unfamiliar with this basic banking formula, the further out in time earnings is discounted, the more dramatically less is the outcome than the current year’s earnings. Simply stated, the value of one dollar is worth a lot less today the further out one receives that dollar; in effect, inflation and opportunity affect its value. In addition, the stronger the discount rate, the greater reduction in value is applied against that dollar over time.<\/span><\/p>\nThere are four key parts of determining risk factor. They are as follows:<\/span><\/p>\n\n- Risk-Free Rate<\/strong> – This is the rate that exists with treasury notes. It is what most investors will accept without any risk.<\/span><\/li>\n
- Equity Risk Rate<\/strong> – A rate an investor is willing to accept given the position they fall within the spectrum of ownership rights, i.e. equity positions range from 4% to as high as 7%. Bond holders are in the 3% to 5% range. Secured bond holders have less risk involved and are in the 2.7% to 3.5% range.<\/span><\/li>\n
- Size Premium<\/strong> – An additional 1% to 4% depending on the size of the company. For example, Walmart’s size premium is around 1%. Mid-Cap investments are in the 2% to 3% range whereas penny stocks are slightly more than 4% premium.<\/span><\/li>\n
- Specific Risk<\/strong> – A factor associated with the purpose of the investment and the ability to sell the respective investments in a timely manner. In this case, Starbucks is stable, and it is easy to dispose of a stock position with Starbucks. A bond position would require a higher specific risk. Overall, specific risk ranges from 0% (McDonalds’ stock position) to as high as 4% for an over-the-counter stock purchase.<\/span><\/li>\n<\/ol>\n
For Starbucks, the risk outcomes are as follows:<\/span><\/p>\n\n- The risk-free<\/strong> rate is 2.25%.<\/span><\/li>\n
- Equity<\/strong> risk for Starbucks is much higher than McDonalds due to the lack of highly stable earnings; if you review its historical earnings, it isn’t considered highly stable and it is heavily reliant on international sales; thus, a 6 to 6.75% risk factor is applicable here. For the purpose of this analysis, 6.5% is used.<\/span><\/li>\n
- Size Premium<\/strong> – Starbucks is definitely considered a large-cap investment; thus, a 1.25% size factor is warranted.<\/span><\/li>\n
- Specific Risk<\/strong> – The purpose of this investment isn’t to hold the stock nor reap dividends, the purpose is to sell it high upon market recovery. There can be several reasons Starbucks’ market value will decrease below intrinsic value, most of these reasons are long-term in nature such as lack of supply, international politics, a negative equity position on the balance sheet and many more. Thus, the specific risk is going to be higher than McDonalds at zero. For the purposes of this calculation, a 1.25% specific risk factor is reasonable.<\/span><\/li>\n<\/ol>\n
Total discount factor is 11.25% which is typically higher than other companies in the S&P 500 with this level of sales and profitability. As a comparison, McDonalds is less than 8.25%.<\/span><\/p>\nGrowth Rate<\/span><\/strong><\/h3>\nWith business, growth is a function of the number of locations and the volume of sales per location. Sales can be further broken down into the growth in the number of items purchased per ticket and of course the growth in sales value per item. Your common novice investor will think that inflation is the number one driver of growth; the reality is starkly different. Growth is mostly driven by the ability to expand into new territories and broaden the product line along with increasing the efficiency of existing locations. Think of how a retail outlet can get more people through the line faster, in effect, faster service.<\/span><\/p>\nStarbuck’s growth over the last 13 years has been driven by the number of locations throughout the world. On January 1, 2009 (13 years ago), Starbucks had 16,930 stores. At the end of the most recent fiscal year, Starbucks had grown to 33,850; that is almost double from 13 years ago. This means Starbucks’ growth rate is driven by the 5.5% growth rate in the number of stores. The overall financial growth rate is about 7.1% per year. Thus, about 75% of the growth is driven by expansion and 25% of the financial growth is driven by increased sales per store some of which is a function of inflation.<\/span><\/p>\nWhen determining a growth rate, the key is to determine if the growth rate can be maintained. Is Starbucks’ expansion rate going to remain at 5.5%? Over the last four years, Starbucks has an average expansion rate of 4.3%. Thus, Starbucks’ is beginning to slow down its expansion rate. If expansion is 75% of the average growth rate, then Starbucks’ actual growth rate is approximately 5.75%. This is significantly slower than the 7.1% historical average experienced over the last 13 years. Thus, a growth rate of 5.75% to 6.1% is an acceptable range for Starbucks with the intrinsic value formula.<\/span><\/p>\nIntrinsic Value Formula Based on Earnings, Discount Rate and Growth<\/span><\/strong><\/span><\/h3>\nThe discounted earnings approach is exercised across three different models – conservative, reasonable and liberal approaches. The approaches vary using the three different earning levels as identified above. In addition, the discount rate will vary about .25% on either side of the pre-calculated rate of 11.25%. The store’s growth rate varies around the 5.9% point which is considered the reasonable expected level of growth over an extended time period. The outcomes are as follows:<\/span><\/p>\nConservative Approach<\/strong><\/span><\/p>\nUsing an average earnings of $3,138 Million per year (the value determined using the sum of the years’ digits method) with a discount rate of 11.5% (.25% stronger than the reasonable determined amount of 11.25%) and a slower growth rate within the range from above of 5.75%, total market value of Starbucks equals $44,001 Million ($44 Billion). This equates to $37.42 per share.<\/span><\/p>\nReasonable Approach<\/span><\/strong><\/span><\/p>\nUsing $3,623 Million as the average earnings with a discount rate of 11.25% and a growth rate of 5.9%, total market value of future earnings equals $53,024 Million or around $45.09\/share.<\/span><\/p>\nLiberal Approach<\/strong><\/span><\/p>\nUsing $3,800 Million as the starting average for earnings and a lower discount rate of 11% with a slightly stronger growth rate of 6.1%, total market value of future earnings is about $58,402 Million or around $49.67\/share.\u00a0<\/span><\/p>\nUnder the three different approaches, intrinsic value ranges from a conservative estimate of $38 per share to a liberal estimate of $50 share. A reasonable outcome places the intrinsic value at about $45 per share.\u00a0<\/span><\/p>\nStarbucks’ Intrinsic Value Using Cash Flows Statement Elements<\/span><\/strong><\/span><\/h2>\nThe intrinsic value formula using cash flows as the basis for intrinsic value calculations is predicated on one primary requirement, there must be some form of terminal value tied to existing assets of the entity at the end of a reasonable time period such as 25 or 30 years out. The simple reality is that Starbucks does not qualify for this. Its physical assets will be some warehouses they currently use for distribution purposes. Thus, unlike fixed asset intensive operations, the discounted cash flows method will have a very small value for terminal value and in reality given the negative equity position of this company, it may have to pay money if it terminated in 25 to 30 years. Furthermore, most of its value is tied to one real aspect of business, selling coffee. It only works if it is an ongoing concern, not an entity which requires strong cash outlays each year to maintain its existing assets. The cash outlay each year funds growth with continued expansion of corporate locations.\u00a0<\/span><\/p>\nTherefore, any form of a cash flows intrinsic value method will either end up with a lower outcome than the earnings method above or produce unreliable results.<\/span><\/p>\nIntrinsic Value for Value Investing (Summary)<\/span><\/strong><\/span><\/h2>\nIntrinsic value calculations are heavily reliant on the ability to predict the future based on the past. The more common risks of consumer demand, legal issues, employee development and expansion are reduced or included with the outcome due to reliance on an extended past of information. However, intrinsic value can not take into consideration those risks that are unusual, infrequent or may remotely exist. With many companies, these are not obvious. However, with Starbucks, this does exist. Starbucks even states this in their annual reports. Go to page 11 and 12 from the 2021 Annual Report. It lists certain macroeconomic risks that are important to include when assessing their impact. For the purpose of this article, there are two:<\/span><\/p>\n\n- Starbucks sells ARABICA coffee; for those of you unaware, arabica coffee can only be grown in a very narrow band spanning the globe. It is grown in a hilly or mountainous zone with proper amounts of rainfall, warming and cooling extremes and requires manual labor to harvest the beans. Unlike beef where cattle can be raised just about anywhere, arabica beans have a limited footprint of possible growth area on this planet. As Starbucks puts it:<\/span>
\nThe availability and prices of coffee beans and other commodities are subject to significant volatility. We purchase, roast and sell high-quality whole bean arabica<\/em><\/span>
\ncoffee beans and related coffee products. The high-quality arabica coffee of the quality we seek tends to trade on a negotiated basis at a premium above the \u201cC\u201d<\/em><\/span>
\nprice.\u00a0 … The supply and price of coffee we purchase can also be affected by multiple factors in the producing countries, such as weather, climate change, water supply<\/em><\/span>
\nquality and availability throughout the coffee production chain, natural disasters, crop disease and pests, general increase in farm inputs and costs of production,<\/em><\/span>
\ninventory levels, political and economic conditions and the actions of certain organizations and associations that have historically attempted to influence prices of<\/em><\/span>
\ngreen coffee through agreements establishing export quotas or by restricting coffee supplies. Speculative trading in coffee commodities can also influence coffee<\/em><\/span>
\nprices. For example, drought conditions in Brazil have and, given continued drought conditions, are predicted to continue to impact coffee prices.<\/em><\/span><\/li>\n- Starbucks relies heavily on sales from two countries with opposing views on the world order – the U.S. and China. At some point in the future, there will be some form of a possible military encounter which in turn will cause China to possibly disallow U.S. based investments to continue operations in China. Per Starbucks annual 2021 report:<\/span>
\n… especially in our largest markets, including the U.S. and China, labor discord or disruption, geopolitical events, war, terrorism (including incidents<\/em><\/span>
\ntargeting us), political instability, acts of public violence, boycotts, increasing anti-American sentiment in certain markets, hostilities and social unrest and<\/em><\/span>
\nother health pandemics that lead to avoidance of public places or restrictions on public gatherings such as in our stores.<\/em><\/span><\/li>\n<\/ul>\nThese two risk factors are not built into the intrinsic value formula and as such should be taken into consideration when developing the buy price for Starbucks. The exposure of these two risks should add a lot of caution for value investors, such that, the margin of safety for Starbucks should exceed 20% of the reasonable intrinsic value formula outcome of $45 per share. For the purposes of this article, the current buy price for Starbucks with this Fund is set at $33 which is a 26.6% discount against the intrinsic value. It is one of the strongest margins of safety that exists in the entire portfolio of potential investments.<\/span><\/p>\nUsing reasonable elements for the discounted earnings formula as follows:<\/span><\/p>\n\n- A reasonable average earnings per year of $3.6 Billion;<\/span><\/li>\n
- A discount rate of 11.25% tied to the following negative financial characteristics of Starbucks<\/span>\n
\n- Negative book value,<\/span><\/li>\n
- Board of Directors poor decision to repurchase shares at high market prices when the company has a negative equity position,<\/span><\/li>\n
- 5400 stores in China,<\/span><\/li>\n
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