The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Starbucks Corporation (NASDAQ:SBUX) delivered an ROE of 113.88% over the past 12 months, which is an impressive feat relative to its industry average of 14.03% during the same period. But what is more interesting is whether SBUX can sustain this above-average ratio. A measure of sustainable returns is SBUX’s financial leverage. If SBUX borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface.
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Restaurants industry may want to choose the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Starbucks’s cost of equity is 9.58%. Given a positive discrepancy of 104.29% between return and cost, this indicates that Starbucks pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Starbucks can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Starbucks is fuelling ROE by excessively raising debt. Ideally, Starbucks should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at 170.11%, which is relatively high. This means Starbucks’s above-average ROE may be driven by its high leverage and its ability to grow profit hinges on a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Starbucks exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Starbucks’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Starbucks, I’ve compiled three essential factors you should further examine:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Starbucks worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Starbucks is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Starbucks? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.