When It Pays to Pay Up Some companies are worth their nosebleed prices. Take Starbucks, for example
(MONEY Magazine) – Think a Starbucks cappuccino costs too much? Check out the stock. At $43 in mid-June, a share of Starbucks (SBUX) cost 47 times what Wall Street analysts expect the coffee-shop chain to earn per share this year. The typical stock in the S&P 500 index trades at just 19 times earnings.
Does it ever make sense to pay such a steep premium? To help you answer that, here are three key questions to ask about any expensive stock.
How fast is it growing?
The more you expect a company's earnings to grow, the more you should be willing to pay for those earnings. Starbucks has a terrific record on that score. Over the past 12 years, its earnings have grown an average of 30% a year. And management is projecting earnings growth of at least 20% a year for the next three to five years. That's three times the growth rate of the typical S&P stock. Of course, it's easy to find companies that have grown fast, or firms that forecast a rosy future. So pay close attention to the next two questions.
How does it fuel growth?
Some companies grow fast by borrowing to acquire other businesses; the risk is that paying off all that debt will erode earnings in the long run. But Starbucks, with little long-term debt and about $380 million in cash, has a stellar balance sheet. It finances new store openings from its own cash flow. And it should be able to keep that cash pumping for a while. Starbucks hasn't raised its prices in three years. "They have plenty of dry powder if they want to raise prices," says Sandy Sanders, analyst at the Evergreen fund, a Starbucks shareholder.
Does the long-term story make sense?
Many good businesses hit a wall once they reach a certain size--they just run out of potential new customers. And if you live in a city where Starbucks is ubiquitous, you might wonder if the world needs another latte outlet.
Starbucks already has 8,000 stores worldwide. It will open 1,300 stores this year and forecasts a total of 25,000. McDonald's, by comparison, has 30,000. So can you imagine a world where Starbucks is nearly McDonald's-size? It's not so nutty. In its hometown of Seattle, there are nearly 200 Starbucks today. But many similar-size cities, including St. Louis, have fewer than two dozen Starbucks. Toledo has no stores. If Starbucks really were reaching the point of market saturation, you'd expect to see its sales in new stores stagnate. In fact, analysts at CIBC say they rose 17% last year, in part because of a relatively recent innovation for the company: drive-throughs.
Stocks as expensive as Starbucks will always be risky, but consider this: In 1991, master value investor Warren Buffett confessed that one of his worst mistakes was not buying Wal-Mart because its shares always looked overvalued. He said this "sin of omission" cost his company, Berkshire Hathaway, $8 billion. Like Wal-Mart, Starbucks is the kind of company that's hard to buy on the cheap, but it seems to have what it takes to pay off big. --DONNA ROSATO