Streetwise

Lauren Rudd

Sunday, August 4, 2013

Investing is Straightforward

Investing is not about deciding what the markets are going to do. Market direction will always be unpredictable. However, a company’s prior accomplishments, earnings, and dividend policy are ascertainable with complete certainty.

Therefore, the problem is relatively straightforward. You simply need to find those corporations with superior records of accomplishment, whose product lines you understand and then forecast future performance. I cannot stress those points strongly enough. Always take a step back and ask yourself, do you really understand how and where earnings occur? If you cannot answer yes in a minute or two, then move on.

Here is an example, do you understand coffee? After all, how much simpler can a product get. Yes, I know that the permutations and combinations of preparing coffee are mind boggling, but in the end it is still only coffee. And the undisputed leader in the world of coffee is Starbucks. The reason is performance.

The king of java recently reported that its third quarter results represent the best across-the-board third-quarter performance in the Company’s 42-year history. For the quarter, earnings-per-share increased 28 percent to $0.55 per share.

In its guidance going forward, Starbucks has indicated that it expects 2013 fiscal year earnings of $2.22 to $2.23 per share. For fiscal 2014, the Company raises that number to $2.55 to $2.66.

Given that we understand Starbucks, the next step would be to estimate a first cut at Starbucks’ intrinsic value. So what exactly is intrinsic value? Well, one good definition is the value of a company’s shares using a discounted cash flow model.

Specifically, intrinsic value is calculated by projecting out some ongoing flow of cash, such as earnings, and then discounting that flow back to the present to obtain its present value. Many of you have asked for an actual example of the calculations so here we go.

To find the intrinsic value of Starbucks using a discounted earnings model, start with a trailing 12-month earnings number, in this case $1.698 billion, which you then let grow at a rate of 18.67 percent (the Street’s 5-year average growth rate) per year for a period of 10 years. Now calculate the present value by discounting that 10-year stream of earnings back to the present using a discount rate of 15 percent, i.e., what I consider an acceptable rate of return.

The result is a net present value for Starbucks’ earnings over the next 10 years of $20.26 billion. Beyond the 10th year and into perpetuity, I lower the earnings growth rate to 6 percent and the discount rate to 12 percent, resulting in a net present value of $40.07 billion. Actual formulas can be found in any basic finance book.

Add those two figures together, subtract long-term debt of $549.6 million, divide by the 743.6 million shares outstanding and you come up with a per share intrinsic value of $81.74. On July 30, the shares closed at 71.93.

Next you might want to check the intrinsic value of the shares using a free cash flow to the firm model. An easy way to do this is to simply go to ValuePro.net and type in a stock symbol. The site will do all the calculations for you. In this case, the intrinsic value is $81.89, which you can see correlates nicely with the prior number of $81.74.

Another way of looking at the problem would be to multiply an earnings estimate by the current trailing twelve-month price-to-earnings (P/E) ratio.

For Starbucks, my fiscal year 2013 earnings estimate is $2.25 per share and the TTM P/E is 34.43. Multiply the two and you have an estimated future price of $77.50, for a projected capital gain of 7.70 percent. In addition, there is a current indicated dividend yield of 1.10 percent.

The question you are probably asking yourself is whether the 34.43 multiple for Starbucks is too high. Yes, it is high but that is not necessarily a deterrent. What it says is that Wall Street has considerable faith in the future of Starbucks.