Is everyone’s favorite barista overvalued? That’s the main proposition behind one of Simply Wall St’s recent articles covering Starbucks (NASDAQ: SBUX). Thanks to the company unveiling an ambitious reset, combined with global store expansion plans in China and India, it’s initially easy to get excited about SBUX stock. However, there’s also another case that shares could be due for a correction.
Per Simply Wall St, SBUX stock features a “narrative fair value” of $99.94. With the security closing at $100.65, the implication is that Starbucks is 1% overvalued. Further, the latest closing price is $103.87. If we apply the same logic, SBUX is nearly 4% overvalued.
It’s not difficult to be lured into this frame of thinking. Right now, SBUX stock commands a trailing-year price-earnings ratio of 78. About the same time last year, this metric stood at 33.32. Therefore, the inference is that SBUX has gotten ahead of the fundamentals.
Frankly, I’m no longer a fan of such rhetoric because I don’t know what getting ahead of the fundamentals means. If we think about this logically, there are many possible interpretations and they’re not interchangeable. The phrase could mean one of the following:
- Investors are assigning a higher probability to a successful turnaround,
- investors expect structurally higher long-term growth,
- investors believe Starbucks deserves a higher quality premium,
- investors are simply willing to pay more for cash-flow stability.
If we cut through the semantics, the argument is as follows: there exists a correct relationship between earnings and the SBUX stock price and today’s market price exceeds that relationship. That’s great but my question would be, where does this relationship come from? It can’t simply be that historically, the multiple was lower because that’s merely an observation. It doesn’t establish that the historical relationship is the correct one going forward.
Moreover, such an argument would imply that SBUX stock consumed more good news than is warranted, meaning that the security must give up some value to reach parity with fair value estimates. Unfortunately, we are yet to see an evidenced model that would justify such a claim.
Is Starbucks Overvalued? Possibly but No One Can Say for Certain
Getting back to the original inquiry, is Starbucks stock overvalued? By overvalued, if you mean that SBUX may eventually shed some basis points from its current level, yes, that’s very much a possibility. Over the past five years, the security has lost roughly 12% of value, meaning that it’s quite a choppy affair. Thus, it may mean revert negatively.
Still, the market will be the ultimate arbiter. Until it decides where SBUX stock should go, we’re all left in the dark. That said, I’m not sure if reading past financial statements offers a probabilistic look into the future. If that were the case, you’d expect historians to be expert forecasters of future geopolitical events or sports statisticians being able to call World Cup games.
What we do know is that, in the modern equities market, much of the trading is based on algorithms or rules-based protocols. As such, the price discovery process is likely not random but is responsive to imbalances of bullish or bearish pressures.
Take SBUX stock and its historical weekly candlestick chart. In the past 10 weeks, the security printed four up weeks, leading to an overall downward slope. This bear-leaning 4-6-D sequence has materialized 47 times on a rolling basis since January 2019. Of these occurrences, the median forward distribution over the next 10 weeks (assuming a starting price of $103.87) has been observed to land between $101 and $110, with probability density peaking near $105.80.
That might sound like an edge but consider what would happen if you simply bought Starbucks stock randomly and held it for a 10-week period. At the endpoint, we would expect a distribution between $102 and $108, with probability density peaking near $104.90. Depending on the specific risk-reward ratio, there’s likely not enough variance between the observed signal and the random baseline for SBUX stock to be worthwhile as a debit-side bullish trade.
So, I don’t actually disagree with the general concept that the popular barista is modestly overvalued. As a heavy entry to a long-term investment, I probably wouldn’t touch it at this hour. It’s not because SBUX stock has gotten ahead of the fundamentals; rather, the observed market mechanics of the aforementioned signal don’t justify an aggressively bullish position.
One Nuance to Consider for Starbucks Stock
Although the forward 10-week distribution of outcomes following the flashing of the 4-6-D sequence for SBUX stock doesn’t lead to great results, the trend isn’t orderly and linear. From the aforementioned sample, the median pathway has been observed to peak at week 5, resulting in an estimated price target of $107.
As such, I probably wouldn’t be comfortable with exceeding the implications of the 105/107 bull call spread expiring Aug. 7. Here, SBUX stock would need to rise through the second-leg strike to trigger the maximum payout of approximately 67%. Frankly, I’m not too hot on the relatively low payout. However, this is somewhat mitigated by the relatively low cost per spread, which comes out to $120.
Breakeven lands at $106.20, which is interesting because the market is assigning a probability of 42.2% that SBUX will reach this threshold. That’s largely calculated by the distance (in terms of standard deviations) the threshold is away from the current spot price, assuming a risk-neutral, log-normal distribution of outcomes.
Where my model comes into conflict with this Black-Scholes-derived calculation is that I don’t necessarily believe that all stock market returns are always log-normal in nature. Instead, I believe that the distribution of outcomes is influenced by the balance of bullish or bearish pressures within a given time period (which in turn may trigger rules-based responses).
Subsequently, I believe that the probability of profit (or the probability of breakeven) should be higher than 42.2%. How much more is a very difficult question to answer.
I do know that in week 5, the expected exceedance ratio (or the chance that SBUX stock rises above the starting price of $103.87) following the flashing of the 4-6-D signal is 61.7%. What would be the probability of SBUX reaching $107 at week 5? We don’t know precisely from the data because we don’t know how many times SBUX stock has equivalently reached the exact price of $107.
That said, the odds are no better than 61.7% and are likely somewhat below this figure, around 53% to 55%, if I had to guess. Even so, this estimate would be conspicuously better than 42.2%, making SBUX stock possibly intriguing for a short-term bullish trade.
