Why Starbucks Needs to Drop Another 10%

Before heart rates rise too quickly, let me say this: I think Starbucks is a first-rate business. As a caffeine addict and coffee shop frequenter, I find the megachain to be surprisingly homey. The oversized chairs, constant 20-somethings music, and endearing quotes on everything from the cups to the bathroom sink make the stores simply desirable places to be. But as a stock, it's been too expensive for too long. Let me show you why.

Bigger than Ronald
I know for growth stocks like Starbucks (NYSE: SBUX  ) , you pay a premium up front. Really, I get it. But let's get off that horse for a second and address the reality behind the valuations.

Paying near 30 times earnings for a $36 billion company is tough to stomach, no matter how "growthy" you might be. As analyst David Trainer pointed out on CNBC, at current valuations, Starbucks needs to grow profits at around 15% compounded annually for the next 10 years to justify its price. The company made around $1.25 billion net in 2011. To earn its valuation, Starbucks would need to bring in just more than $5 billion after tax. That would put it in the same league as McDonald's (NYSE: MCD  ) , which earned around $5.5 billion in net income for 2011. The only difference is that McDonald's is a much bigger, much more established chain that trades around 16 times earnings -- nearly half that of Starbucks.

So on a day when the market crosses 13,000, Starbucks is down 10%. My math is based on today's share price -- not before the 10% drop.

To get more in line with the realm of reality, Starbucks needs to continue to drop. I'm sorry, investors, but it's for your own good. You can either sit on this stock for a decade and watch it wobble around as inflation eats your lunch, or you can buy in when the stock drops even more and dollar-cost-average yourself into the black.

Which would you rather have?

"But it's Starbucks!"
Yes, yes -- I know Starbucks is the first company to put a coffee shop on the moon (what?), but we have to play by the rules, guys. Look what happened when we all bought Netflix (Nasdaq: NFLX  ) because it changed the way we watched TV and movies. Some of us paid $200 per share for a stock that should trade around $40 and today is a little under $60. The stock didn't fall because Netflix is a bad company; it's not. It fell because Mr. Market woke up from his drug-induced coma and realized it's hard for a company to grow double-digit bottom lines for eons without running into a single roadblock. It just doesn't work out that way.

The truth is that the best thing this stock could do for your portfolio is to drop another 10% or even 20%. Realistically, we could see this before the end of the year, as it looks like the market is beginning to see the light. If you are a current Starbucks shareholder, or you're looking to get in, I would wait patiently for this to happen and have my hand on the buy button when it does.

As for now…
Starbucks ain't goin' nowhere. It's a caffeine-pushing powerhouse with amazing profitability and top-level management. But in the meantime, it may be worth turning your attention to more reasonably priced stocks with similar stories to that of Starbucks.

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Fool contributor Michael Lewis owns none of the stocks mentioned. You can follow him on Twitter @mikeylewy. The Motley Fool owns shares of Netflix, McDonald's, and Starbucks. Motley Fool newsletter services have recommended buying shares of Starbucks, Netflix, and McDonald's. Motley Fool newsletter services have recommended writing covered calls on Starbucks. Motley Fool newsletter services have recommended creating a bull call spread position in Wal-Mart Stores. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (2) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 30, 2012, at 12:07 PM, rojostyle wrote:

    With it's 10% drop it's at 26 p/e for last 4 quarters p/e not 30. Also you should always do p/e ratios on estimated future earnings b/c who cares about what they once reported.

    Sbux is a buy on any dip and hold for 5 years and thank howard schultz for every raised dividend that will inevitablly happen til than.

  • Report this Comment On July 30, 2012, at 4:15 PM, johaba wrote:

    I always love reading these articles after the stock has been recently reccomended as a buy in the Motley Fool services.

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