If you've been reading these duels for any length of time, then chances are you know how today's duel over Starbucks (NASDAQ:SBUX) will run. My esteemed Foolish colleague, Nate Parmelee, will point out to you what a wonderful business Starbucks is. I will then dutifully reply "yes, but."
Specifically, "Yes, but it costs too doggone much."
I've said it so many times that I'm starting to get hoarse (no mean feat, when all I'm doing here is typing): A great company does not necessarily make for a great investment. If you pay too high a price, you just might "pay the price."
I know that Starbucks bulls think there's no price too high for a great cup of coffee, or for a great coffee company. And it's true that Starbucks has historically sported a high price multiple to earnings. But just because something has always been so, doesn't mean it always will be so.
Remember the Bubble
Remember the sky-high multiples we were asked to pay for profits back then in 2000. Five years ago -- several months after the Bubble had already begun collapsing -- General Electric (NYSE:GE) was still selling for a trailing P/E ratio of about 40. Intel (NYSE:INTC) was trading for about a 30 P/E. Both were great businesses -- but both cost too much.
Today, GE trades for a multiple of 19. You can buy Intel for 17 times trailing earnings. The moral of the story: High P/E stocks eventually become reasonably priced. That's great news if you want to buy them in the future -- less great if you own them while they're still overpriced.
Take the more recent example of eBay (NASDAQ:EBAY). Examine its chart over the last year and watch how the company's high P/E contracted severely in January when the company reported a single item of "bad" news, forecasting lower earnings because it was making some extra investments in China. Notice how Mr. Market chopped the stock price nearly in half over the four ensuing months. A year later, shareholders are still down more than 30%.
Price-to-earnings to the moon
Just like GE, Intel, and eBay, Starbucks is a great business. But just like those other great businesses were, Starbucks is overpriced today. Even great companies stumble, and when they do, shareholders get burned. With a trailing P/E of 49, and an expected annual growth rate below 25%, this coffee is boiling and ready to spill in someone's lap.
Free cash flows slowly
Perhaps the idea of paying 49 times earnings isn't enough to scare you away from this stock. If so, then take a look at Starbucks' free cash flow situation. Free cash flow, defined as cash from operations minus capital expenditures, reflects the true cash profitability of a business. In Starbucks' case, it shows that Starbucks doesn't generate nearly the amount of cash that you might think it does, judging just from its GAAP income statements.
Over the last 12 months, Starbucks has reported GAAP net income (profits as determined by generally accepted accounting principles, or "paper profits") of $474.9 million. But while accountants and CNBC talking heads might be happy with paper profits, Fools dig deeper. We're interested in the company's green paper profits -- its free cash flow.
After comparing the company's cash flow statements to income statements, I've determined that Starbucks generates far less free cash flow than it does paper profits. Over the last 12 months, Starbucks generated only $334.1 million worth of free cash flow -- fully 30% less profit than its GAAP numbers would suggest.
Valuation matters
And that's really the basis for my argument that you shouldn't buy Starbucks. I've got nothing against the business -- it's a modern success story, no doubt about it. But with a P/E more than twice as large as its projected long-term growth rate (22%), and a price-to-free cash flow ratio nearly three times as large, this coffee just costs too darn much.
But, wait! You're not done. This is just a quarter of the Duel! Don't miss the bullish view, Rich's rebuttal, and Nate's final word. When you're done, you're still not done. You can vote and let us know who you think won this Duel.
eBay is a Motley Fool Stock Advisor selection.
Fool contributor Rich Smith does not own shares of any company named above. If he did, The Motley Fool would require him to tell you so. We're sticklers about things like that.
