Starbucks Financial Assessment

Firms may be successful by satisfying customer needs, but their ultimate accountability for financial performance is to the owners of the firm. Actions undertaken by quoted firm will usually have the direct, or indirect, aim of generating revenues and profits for the firm, and therefore the owners (Tarraf, 2012). When investors assess a potential investment they will look at the financial performance of a firm, assessing the past performance, with consideration of the way current and expected strategies will impact on the organizations performance, in the context of the expected macro-environmental conditions (Bodie, Kane, & Marcus, 2014). The investors will assess the share price of the firm, being more likely to make a purchase if they believe the value of the share is likely to increase with a significant amount of the assessment based on assessments of past performance (Hens & Rieger, 2016; Nellis & Parker, 2006). This report examined and demonstrates this process looking at the performance of Starbucks, assessing the performance using quantitative and qualitative data, which will also be used to assess the share value, based on the Constant Dividend Growth Rate model, with the analysis leading to a recommendation regarding investments in Starbucks stock.

Financial analysis is an important element of investment assessment, but the quantitative assessment should be accompanied by a qualitative analysis to provide context for the results (Myers & Majluf, 1984). This section examines the background and position of Starbucks within the industry, and the way the firm is viewed by investors by examining recent stock price movements.

Starbucks is a globally recognised coffee house chain, which also roasts, markets, and retails coffee. Founded in 1971 in Seattle with a single store specialising in the roasting of coffee (Schultz & Yang, 1998). However, it was under the leadership of Howard Schultz who acquired the company from the founders in 1987 that the company started to grow (Schultz & Yang, 1998). By 1989 the company was roasting 2 million pounds of coffee per year, and had 46 stores, and by the time the initial public offering was made in 1992 the company had 140 stores, with revenues exceeding $73 million (Schultz & Yang, 1998).

The company started its international expansion in 1996, with the first overseas stores opening in Tokyo in Japan, followed by the Philippines in 1997, and the UK, as well as Thailand, Taiwan, and New Zealand in 1998 (Starbucks, 2017a). The company has also undertaken related diversification, expanding the product range into grocery stores, and later undertaking sales of coffee brewing equipment as well as the coffee, online (Starbucks, 2017a).

By December 2016 had a total of 24,893 stores located across the globe (Loxcel Geomatics, 2017), with the expansion aided significantly through the use of the franchise model (Schultz & Yang, 1998). The expansion model has been particularly useful, as it has facilitated a cost-effective method of moving into many different countries while limiting capital requirements (Nijmeijer, Fabbricotti, & Huijsman, 2014). The franchising model allowed the brand to expand with third parties making investments in branded cafes, paying a fee for using the name, as well as purchasing the inputs from the franchisor (Min & Min, 2011). This provided revenue for Starbucks, at the same time as limiting the risk and benefiting from local knowledge provided by the local investors (Mintzberg, Quinn, & Goshal, 2003).

The organisation has faced some challenges, decreasing demand following the recession, and difficulties associated with cannibalisation reduced sales in some areas, and resulted in a restructuring of the firm including some closures (Schultz & Gordon, 2011). However, when examining the organisation over the last five years, the performance appears to be solid with the latest set of accounts which ended in September 2016 showing a revenue of $21,316 million with a gross profit margin of 10.07% and a net profit margin of 13.22%. The firm has a positive outlook, seeks to enhance its reputation with string CSR strategies, and has the mission statement "To inspire and nurture the human spirit -- one person, one cup and one neighborhood at a time" (Starbucks, 2017b). The current growth plans of the organization include continued expansion, but rather than simply maintaining the existing strategy, the organization is diversifying the way it sells coffees including setting up more drive-through outlets, as well as new smaller walk-through units in areas such as Boston, Seattle, and New York (Trefis Team, 2016)

These all appear to be positive signs, however, while internal factors other important, it is also necessary to consider the company in terms of its industry position, as this will also have a potential impact on its future performance (Bodie et al., 2014)

Starbucks is a global leader. The firms' core market is the US, where 54.5% of its stores are located (Loxcel Geomatics, 2017) and 73.7% of its net revenues originate (Starbucks, 2017b). The firm has a dominant passion in the US, where it has 42.4% of the total gourmet coffee chain market (Statista, 2015). It is ahead f the leading competitor Dunkin Doughnuts, under the Dunkin' Brands Inc. banner which has a 25.5% market share, with the remaining 32.1% market being fragmented, made up of many smaller players (Statista, 2015). The firm has faced a number of challenges in the United States, where the rapid expansion had resulted in significant levels of cannibalisation and prohibitive overhead costs impacting negatively on profits (Schultz & Gordon, 2011). The negative publicity associated with the closing of the stores, harm the reputation in short-term, as it helps the organisation to become more profitable (Schultz & Gordon, 2011). In reality, the organisation may not to be increasing its market share due to the growth in the market, but it is increasing the number of customers served, 2013 an estimated 1,959 million customers were served in the United States, this rose by 5.84% in 2014 to 2,073 million, by 5.51% in 2015 to 2,188 million and an estimated 2,366 million in 2016 which was 8.15% growth in customer numbers (Trefis Team, 2016).

The company maintained its position as the leader in the gourmet cafe coffee market through a high level of control over the supply chain to maintain quality, as well as differentiation of the products sold. During the Christmas period the company changes the cups to the red cups, and offers seasonal specialities which are often very popular, such as the eggnog latte, while at Halloween there is the Halloween spiced lactate, a brief review of the company's social media will demonstrate the popularity of these products. The organisation is also investing in research and development to improve existing products and bring new ideas to market, which was seen recently with the freeze-dried Starbucks Via brand (Schultz & Gordon, 2011).

Internationally, the company is also a leading brand, very well known, supported through excellent marketing, including product placements in blockbuster films, as well as extensive use of social media marketing (Phan, Thomas, & Heine, 2011). With the company demonstrating increasing growth internationally, especially the Asian markets, the organisation also appears to be well placed internationally (Starbucks, 2017a).

To assess the way in which investors appear to be perceiving the current and potential future performance of Starbucks, rather than just considering the number of stores in market share, the stock price movements can also be considered.

Examining the stock price movements of Starbucks indicates that the last five years have been relativity good for Starbucks, as shown in figure 1 below.

Figure 1; Starbucks Stock Price January 2012 -- January 2017

(Morningstar.com, 2017)

At the beginning of the five-year period, the stock price was $24.08 and the growth has been impressive, as value for the stock on the 13th of January 2017 was $57.85. However, this is a long-term performance and it is the short-term that is more likely to reflect the current status of the firm. Looking at the last year the performance is far more volatile, as shown in figure 2

Figure 2; Starbucks Stock Price Performance January 2016 -- January 2017

(Morningstar.com, 2017)

Over the last year, the share price has risen and fallen, starting at $58 before falling to $54.14 in February, ending the year at $57.85, indicating only modest growth while the graph indicates there could have been some significant losses depending upon purchase and sale dates if the investment took place within this year's (Morningstar.com, 2017).

Over the last 52-week range of the stock price has been between $50.84 and $61.74 (Morningstar.com, 2017), with the firm suffering from bad news indicating loss of market share and constrained growth (Trefis Team, 2016). However, potential investors, as well as existing investors may have concerns when the performance of Starbucks is considered compared to alternative investments. Generally, Starbucks is likely to be considered as a relatively low-risk investment, beta of 0.73 (Morningstar.com, 2017). The beta is not a direct measure of risk, but an indicator of volatility regarding the way in which the share price moves compared to the stock market as a whole (Myers & Majluf, 1984). However, the performance of the firm is relatively lacklustre, especially compared with the S&P 500, a common index used to assess share prices. This is shown below in figure 3.

Figure 3; Comparing Starbucks performance with the S&P 500 January 2016-January 2017

(Morningstar.com, 2017).

The movement of the Starbucks stock is reflective of the stock market as a whole, with peaks and troughs at the same time, but the period between April to June significantly underperformed leading to returns that are significantly less compared to the S&P 500. However, while the past performance over the last year may have been disappointing, it is the financial results of the firm that are likely to be of most interest, which can be considered for a quantitative analysis.

The stock price movements of a company may reflect financial performance, but can also reflect many subjective elements, including individual feelings, general market conditions, as well as rumours and/or unsubstantiated news (Howells & Bain, 2007). For this, the elements of liquidity, profitability, capital structure, market value and stock valuation can all be considered.

Liquidity deals directly with the ability of a firm's short-term survival potential, if an organisation does not have sufficient cash to pay its liabilities, it will end up defaulting and failing. Therefore, the liquidity ratio is important. The primary liquidity ratio is the current ratio, which is calculated by dividing the level of current assets by current liabilities. Where the ratio is one, current assets are exactly equal to current liabilities, a firm should generally have a ratio above one (Elliott & Elliott, 2015). The current ratio for Starbucks is shown below.

Table 1; Current ratio for Starbucks 2012-2016

Current ratio

2012

2013

2014

2015

2016

Current assets (a)

4,200.0

5,471.0

4,169.0

4,353.0

4,761.0

Current liabilities (b)

2,210.0

5,377.0

3,039.0

3,654.0

4,574.0

Current ratio (a/b)

1.90

1.02

1.37

1.19

1.04

This shows that the firm has sufficient liquidity, and while liquidity has declined since 2012, the organisation is able to meet its current obligations out of its current assets. The quick ratio, also known as the acid test, is a similar calculation, but deducts the level of inventory from the current assets (Elliott & Elliott, 2015). This is known as the acid test, as if the organisation needs to raise funds quickly, it is possible the inventory may not be realised through its full value (Howells & Bain, 2007). This is shown in table 2 below.

Table 2; quick ratio Starbucks 2012-2016

Quick Ratio

2012

2013

2014

2015

2016

Current assets (a)

4,200.0

5,471.0

4,169.0

4,353.0

4,761.0

Inventory (b)

1,242.0

1,111.0

1,091.0

1,306.0

1,379.0

Net current assets (a-b) (c )

2,958.0

4,360.0

3,078.0

3,047.0

3,382.0

Current liabilities (d)

2,210.0

5,377.0

3,039.0

3,654.0

4,574.0

Quick ratio (c/d)

1.34

0.81

1.01

0.83

0.74

Where an organisation has a more rapid turnaround on the inflow of cash compared to the outflow, it is quite usual for the quick ratio to be below one (Elliott & Elliott, 2015). The quick ratio may be of some concern, as in 2016 it was at its lowest level, this was due to the inventory being at its highest level. However, when placed in the context of the increased sales, it is not necessarily cause for concern, but maybe notable.

The profitability is one of the primary ratios considered by investors. The most common measure is the net profit margin (Bodie et al., 2014). This is the profit, which is the revenue less all of the direct and indirect costs, including interest and depreciation, but before tax, divided by the revenue and expressed as a percentage (Elliott & Elliott, 2015). The calculation for the net profit is presented below in table 3.

Table 3; it profit for Starbucks 2012-2016

Net Profit

2012

2013

2014

2015

2016

Revenues

13,300.0

14,892.0

16,448.0

19,163.0

21,316.0

Net Income (before tax)

1,384.0

8.0

2,068.0

2,757.0

2,818.0

Net profit margin

10.41%

0.05%

12.57%

14.39%

13.22%

This measure is highly indicative of the way in which the organisation has been operating. The profit appears to be generally improving, a 10.41% in 2012, then declining in 2013 to 0.05%. It is known that 2013 was a difficult year, but the subsequent years appear to indicate there has been an improvement. In 2015 the net profit was 14.39%, and while the percentage level has declined to 13.22% in 2016, it is notable that the amount of net profit has increased. The figures appear to indicate that the company is doing quite well, and has recovered from the difficulties in 2013.

While the profit margin is a good measure of performance, profitability may also be considered in the context of return on total assets and return on equity. These two measures take the net profit and divide them by the total assets or the equity in order to indicate the effectiveness of the use of assets or equity in the organisation (Elliott & Elliott, 2015). These ratios are shown in tables 4 and 5.

Table 4; Return on assets for Starbucks 2012-2016

Return on Assets

2012

2013

2014

2015

2016

Net profit (a)

1,384.0

8.0

2,068.0

2,757.0

2,818.0

Total assets (b)

8,219.0

11,517.0

10,754.0

12,446.0

14,330.0

Return on assets (a/b)

16.84%

0.07%

19.23%

22.15%

19.67%

It appears the organisation is effectively utilising its assets, but in line with the net profit, there has been a slight drop in 2016. Overall, the ratio has been improving, with both the net profit rising, as well as the level of total assets increasing. This appears to be a positive sign.

Table 5; Return on equity. At 2012-2016

Return on equity

2012

2013

2014

2015

2016

Net profit (a)

1,384.0

8.0

2,068.0

2,757.0

2,818.0

Equity (b)

5,109.0

4,480.0

5,272.0

5,818.0

5,884.0

Return on equity (a/b)

27.09%

0.18%

39.23%

47.39%

47.89%

The return on equity may also be seen in a positive light, with what appears to be a significant increase rising from 27.09% in 2012, 247.89% in 2016. However, when looking at the underlying components of this ratio, it is notable that while the profit has been increasing, the total level of equity within the organisation has not kept pace, and has been increasing at a much slower rate. Therefore, while there is no cause for concern in terms of the firm's performance, it may be noted that the level of equity in the firm is not growing at a comparable rate. If this organisation were not paying dividends, this would indicate a potential constrained in terms of the ability for the stock to demonstrate capital growth (Howells & Bain, 2007). However, as the organisation pays dividends, a lower growth in equity may be acceptable. However, with a growing organisation, and a relatively constrained growth of equity, there is a need to look at the organisation's capital structure.

The capital structure of the firm is often considered by investors. While Modigliani & Miller (1958) theorised that the underlying capital structure of an organisation should not impact on the share price, the reality is that many stockholders associate more highly leveraged firms with greater risk (Howells & Bain, 2007). Within this context, it may also be argued that higher levels of debt may increase the overall cost of debt, as lenders may also perceive a firm to be more risky, due to lower levels of security, as well as the firm facing a higher interest payment burden. Therefore, one ratio often used as the debt ratio, which divides the total level of debt by the total assets (Elliott & Elliott, 2015). The higher the ratio, the greater the proportional level of debt within an organisation (Elliott & Elliott, 2015). The debt ratio for Starbucks is shown in table 6 below.

Table 6; Debt ratio for Starbucks 2012-2016

Debt Ratio

2012

2013

2014

2015

2016

Total debt (a)

3,110.0

7,037.0

5,481.0

6,628.0

8,446.0

Total assets (b)

8,219.0

11,517.0

10,754.0

12,446.0

14,330.0

Debt ratio (a/b)

0.38

0.61

0.51

0.53

0.59

This ratio indicates that the organisation has seen an increase proportional level of debt compared to assets. The ratio has increased from 0.38 to 0.59 in four years, with total debt more than doubling, while assets have increased, but not in proportion to the level of debt. Therefore, the company has become more leveraged. However, a 0.59 ratio is not necessarily cause for concern. With increased debt, a consideration may be the affordability of the increase in debt, which can be considered by looking at the interest rate coverage ratio.

The interest rate coverage is calculated by taking the net profit and adding back the interest, and then dividing the net profit plus interest by the interest that is payable, which indicates how many times the net profit before interest could cover the interest payments (Elliott & Elliott, 2015). The interest rate coverage is shown in table 7 below.

Table 7; interest rate coverage for Starbucks 2012-2016

Interest rate coverage

2012

2013

2014

2015

2016

Net profit (a)

8.0

2068.0

Interest (b)

33.0

28.0

64.0

71.0

81.0

Earnings before interest (a-b) (c )

-20.0

2004.0

Interest rate coverage (c/b)

40.94

-0.71

31.31

37.83

33.79

This shows that the organisation appears well-placed to cover its interest payments, apart from in 2013 when the net profit was very low. Therefore, while debt levels may have increased, it appears that this is completely affordable, and with a more highly geared firm, it may be that the organisation is taking advantage of more opportunities, which may benefit the shareholders in the long-term through the generation of more profits (Howells & Bain, 2007).

When examining the market value of the share, a common measure is the price-earnings ratio. This is calculated by taking the earnings of the company and dividing them by the capitalisation, alternatively it may be calculated by taking the earnings per share and dividing it by the price for the stock, and indicates a number of years it would take the organisation to earn its market value (Elliott & Elliott, 2015). The nature of this calculation indicates that the value will change from day to day, as the share price or market capitalisation values from day-to-day. The current forward P/E ratio is 23.3, while the trailing P/E ratios 30.45 (Yahoo Finance, 2017). This calculation will vary from day-to-day.

As investors purchase an investment with the aim of making a profit, it is the potential profit or returned it is often the most important element in the investment appraisal (Bodie et al., 2014).

Many theorists have sought to develop models that explain how and why a share which is a particular price, based on the level of return that it is expected to create. One of these is the constant growth model, also known as the Gordon model. The Gordon model may be utilised to assess the current price of a security, based on the return it is expected to provide. The model assumes that dividends will remain constant. The formula for this calculation is

Current price = current annual dividends (1+ g)/k-g

In this equation k is the rate of return required by investors in the market, g is the expected growth rate of the annual dividends.

To calculate the expected current stock price for Starbucks it is necessary to identify the relevant input figures. The current annual dividends, based on the preceding four quarters are $0.85, which are the current price is giving a yield of 1.47%.

The next consideration is the rate of return required by investors. This may be considered using the capital asset pricing model, which is the rate of return for a given share based on the risk associated with that stock. The CAPM formula is

Rate of return required = rate of return for a risk-free security + beta for the stock (the market expected rate of return - risk-free rate)

Using this to calculate the required rate of return, if it is assumed that the average rate of return for a risk-free investment is 2.4% which is the rate for a 10-year government bond (Bloomberg.com, 2017), and the market expected rate of return is 10%, which is the average observed between 1928 and today, and the beta is 0.73, applying the equation above gives a required rate of return of 7.95%. This can now be used in the constant dividend growth rate model. The only remaining consideration is the expected growth rate of the annual dividends. The dividends have increased and decreased, and are now increasing again. The last two increases have been a 25% increase in dividends, but it is unlikely this is going to continue. Therefore, for the purposes of this calculation, we will assume a 5% increase in dividends.

Based on current annual dividends of $0.85, a required growth rate of 7.95%, and an assumed dividend growth rate of 5%, the current share price should be $30.25