Starbucks Corporation (SBUX)mmoore.ba.ttu.edu/ValuationReports/Fall2006/Starbucks.pdf · Starbucks...

November 1, 2006

Starbucks Corporation (SBUX) Analysis By:

Sarah Lamb [email protected]

Jeff Leaverton [email protected]

Rachel Morris [email protected]

Lauren Wein [email protected]

Scott Weiser [email protected]

1

Starbucks Valuation

T A B L E O F C O N T E N T S

Executive Summary………………………………………….3

Company Overview.…………………….……………………6

Industry Structure and Profitability………….………….6

Value Chain Analysis……………….…………….….……11

Firm Competitive Advantage Analysis…………….…..11

Accounting Analysis……………………………………….12

Key Accounting Policies………………..………..12

Degree of Accounting Flexibility…………..…..14

Accounting Strategy……………………..………15

Quality of Disclosure……………………..……..16

Potential “Red Flags”………………………..…..19

Undo Accounting Distortions……………..…..19

Financial Ratio Analysis…………..……………………20

Capitalized Lease Ratios……………………….22

Operating Lease Ratios………………………...23

Trend Analysis…………………………………………..23

Liquidity Ratios………………………………….24

Efficiency Ratios………………………………...24

Profitability Ratios………………………………25

Capital Structure Ratios………………………25

Ratio Changes After Capitalization…………25

Financial Statement Forecasts……………………….27

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Firm Valuation…………………………………………..29

Cost Of Debt……………………………………29

Cost Of Equity…………………………………29

WACC……………………………………………30

Credit Risks……………………………………30

Intrinsic Valuations……………….…………31

Residual Income Valuation………………..31

AEG Valuation………………………….…….33

Long Run ROE Valuation…………….……34

Free Cash Flow Valuation…………….…...34

References……………………………………………..36

Appendices.…………………………………………37

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Executive Summary

Starbucks Corporation

Investment Recommendation: Over-Valued, Sell 11/01/06

SBUX – NasdaqGS 38.26 EPS Forecast

52 week range 28.72-40.01 FYE 11/01

2006(A)

2007E

2008E

2009E

Revenue (2005) 7.44B EPS 0.91 1.09 1.26 1.44 Market Capitalization 26.61B Shares Outstanding 756.07M Valuation Estimates Dividend Yield N/A Actual Current Price 35.29 3-month Avg Daily Trading Volume 8,036,250 Percent Institutional Ownership 65.50% Ratio Based Valuations P/E Trailing 49.79 Book Value Per Share (mrq) 10.83 P/E Forward 33.10 ROE 23.88% PEG Forward 1.69 ROA 16.46% Dividend Yield N/A Long-term growth rate (5 yr) 22.00% M/B 10.80 Cost of Capital Est. R2 Beta Ke Ke Estimated 16.30% Intrinsic Valuations 10-year .20472 1.6685 16.30% Discounted Dividends N/A 5-year .20443 1.6645 16.30%

Free Cash Flows 33

2-year .20342 1.6604 16.40%

Residual Income 5.13

6-mon .20242 1.6587 16.40%

Abnormal Earnings Growth 2.69

Published 1.17 Long-Run Residual Income Perpetuity 0.00 Kd 5.59% After Tax Kd 3.47% WACC 8.04%

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Starbucks Corp. has established itself as one of the top producers of

specialty food items in the world. With an unwavering commitment to quality

they have been able to produce a product that has found its way into the hearts

and minds of their customers moving Starbucks into the forefront of the industry.

Starbucks has become such a success that many of its competitors have been

forced to leave the market or been acquired by Starbucks itself. Through their

commitment to a superior product quality and variety Starbucks has been able to

keep consumers coming back day after day. They have also taken great steps in

investing in their brand image to the point that consumers will accept no

substitutes and will go out of their way and pay a premium for Starbucks coffee.

When looking at Starbucks from the surface it appears that everything is

fine. After analyzing their financial reports Starbucks appears to be very cavalier

with their accounting policies by not capitalizing their operating leases and not

fully disclosing all of their financial information. They did not disclose any of

their interest rates for their liabilities. Their lack of disclosure accompanied with

the fact that Starbucks does not capitalize any of their operating leases was a

cause of concern and raised the chance of manipulations taking place within the

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financial statements. Some of the financial ratio tests that were run over the

previous five years resulted in some very inconsistent results. These results

accompanied with the apparent lack of disclosure for certain items raised a few

“red flags” when valuing the Starbucks Corporation.

The first step in forecasting the future value of our firm was to calculate

the value of the firm for the fourth quarter of 2006. Once we were able to

determine the value of the firm for 2006 we then estimated the future value for

the next ten years. We then found average growth rates from the previous

years and estimated them out for the next ten years. We took into account that

we did not think that Starbucks would not be able to sustain its abnormally high

growth rate. We looked how Wal-Mart grew as its growth as a company was

similar to that of Starbucks.

The last thing that we did was valued our company using several

valuation models. Some models such as the dividend growth model and the long

run return on equity did not apply to Starbucks because they do not pay

dividends and their Return on Equity is equal to the Growth in book value. In

order to value Starbucks we first computed the necessary components such was

cost of debt, cost, of equity, and the weighted average cost of capital. With

these components in place we were able to run valuation models on Starbucks in

order to find whether it was over or under valued. In all of our valuation models

we found that Starbucks is significantly overvalued and we strongly recommend

selling.

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Company Overview

The Starbucks Coffee Company was founded in 1971, opening its’ first

store in Seattle, Washington. Starbucks’ products consist of a variety of hot and

cold coffees, teas, juices, and pastries. Starbucks stores also sell non-food items

such as espresso machines, coffee brewers; drink related items consisting of

mugs, thermoses, plastic drink containers, and coasters.

In 1992, Starbucks became a publicly traded company on the NASDAQ

National Market under the symbol “SBUX”. As of July 2006, there are 11,784

Starbucks locations worldwide and the company headquarters is located in

Seattle, Washington. The increasing popularity and customer loyalty has led to

Starbucks being the only major player in the specialty coffee industry and has

enabled the company to expand into new markets with relative ease and

efficiency. Last year Starbucks has a market capitalization of $25.59 billion

dollars in 2005 while also seeing its sales increase by over one billion dollars.

Industry Structure and Profitability

Rivalry Among Existing Firms

The coffee industry is a highly competitive industry in that coffee is served

at almost every restaurant, diner, and convenient store in the nation. Most

homes brew their own coffee as a more convenient and less expensive way of

getting their daily coffee fix. Thirty years ago people who wanted a premium

cup of coffee would head to their local coffee houses or their corner cafes in

order to obtain the highest quality of coffee. Today with the onslaught of

corporate chains these local establishments have become an archaic symbol of

the past.

Starbucks has differentiated itself from its competitors by offering higher

quality of coffee which it charges a premium price for. While its prices are much

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higher then that of its competitors Starbucks has such a strong brand loyalty that

it has been able to consistently outperform other coffee houses. Starbucks, as

with all local cafés, also has to compete against home coffee producers such as

Procter & Gamble’s (NYSE: PG) Folgers brand of coffee and Kraft Food’s (NYSE:

KFT) Maxwell House brand. With a high concentration of competitors Starbucks

has been able to thrive by offering a high quality product that commands a high

brand loyalty.

Starbucks has a differentiated itself from its competitors by offering a vast

array of coffee flavors from all ends of the spectrum. This allows them to create

unique flavors that can only be found at Starbucks. Starbucks also offers baked

goods, sandwiches, and recently added movies and music to its ever expanding

line of goods. With such a wide variety of specialty goods available for sale

Starbucks is able to differentiate itself from its competitors.

2001 2002 2003 2004 2005 Sales Volume $2,648,980,000 $3,288,908,000 $4,075,522,000 $5,294,247,000 $6,369,300,000Total Assets $1,851,039,000 $2,214,392,000 $2,729,746,000 $3,386,541,000 $3,514,065,000Stock Price

Performance (per share)

$7.14–$12.23 $9.40–$12.59 $10.05–$16.58 $16.45–$31.18 $22.78–$31.93

With an expanding market the likeliness of excess capacity is minimal.

However if Starbucks were forced to close a store at a particular location the exit

barriers would be small for such a large corporation. Any equipment in the

closed store could be moved to a new store and there are now regulations for

exiting the industry.

Threat of New Entrants

One area of concern for Starbucks is that startup costs for local coffee

shops are relatively low and many people open cafés everyday in the hopes of

offering a local alternative to the corporate chains. Fortunately for Starbucks,

these cafés do not have any brand recognition or loyalty and more often then

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not are quickly forced to leave the industry. However in the past few years

many well established companies have started to move into the coffee industry

by offering their own select blend of coffee and have kept startup costs low by

offering them at their existing stores.

While companies have been offering coffee to people as a compliment to

their featured product for decades, Starbucks was one of the first to actually

specialize in making coffee as their primary objective. Before Starbucks people

used to order coffee as a secondary product and Starbucks has reversed that

trend making coffee the main attraction while everything else is secondary. This

has allowed Starbucks to gain a competitive advantage over most of its

competitors. Being the first mover in an industry is accompanied with many

advantages. Starbucks has established a long standing relationship with its

suppliers and they continually ensure that they are getting the highest quality

goods at a fair price. The coffee industry has a high concentration of suppliers

with new ones appearing almost daily. This has led to coffee being a relatively

cheap commodity.

Threat of Substitute Products

One problem that all coffee houses face is that they are constantly

battling the threat of substitute products. Substitute products for coffee can be

found almost anywhere beverages are sold. Soda, tea, and energy drinks

compete for the same customers. So far the coffee industry has been able to

compete by offering a wide variety of choices. This diversification has been

accomplished through new and creative ways of manufacturing different flavors

of coffee. These innovations have developed a strong brand loyalty between the

product and the consumer.

Starbucks has made considerable investments in brand image and

customer loyalty. This has been made prevalent in people’s unwillingness to

accept Starbucks’ substitutes shows just how much brand loyalty they posses as

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well as enabling them to charge premium prices for their products. When people

go out of their way and pay higher prices for a product that has readily available

substitutes it shows that there is a something about that product that consumers

feel can not be found anywhere else. Much of this brand loyalty comes from the

quality of the products that Starbucks produces. This constant improvement in

quality starts at the very base of Starbucks operations and moves continuously

up to the highest level of the corporation. While there is a high concentration of

substitute products within the coffee industry Starbucks has been able to thrive

off its ability to create unique and quality products.

Bargaining Power of Buyers

When it comes to the coffee industry the price sensitivity is very high.

Since coffee is such a common commodity consumers are not willing to pay

more where there are virtually no switching cost involved. A cup of coffee is

relatively cheap and the consumer knows exactly what it is that they are getting.

Consumers also have a considerable bargaining power over coffee producers.

Since a cup of coffee is available just about everywhere if the consumer does not

want a particular brand it can find an alternative with relative ease and with little

to no switching cost.

Starbucks is unique in that it charges a premium price for its coffee and

the consumers have little to know bargaining power. It accomplishes this by

diversifying itself from other coffee products through a higher quality and its

unique coffee flavors that are only offered by Starbucks. In this case people are

left with little to no price sensitivity or bargaining power. This has been key to

the long run success of the industry.

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Bargaining Power of Suppliers

While most buyers in the coffee industry focus on finding the cheapest

suppliers possible, Starbucks is willing to pay more for the highest quality good

on the market. They only choose the finest ingredients for their products and

demand the best. They are willing to pay a premium to their suppliers and they

have a considerable amount of bargaining power. Starbucks stays true to its

mission statement and spares no expense in purchasing the highest quality

ingredients for its products.

Starbucks is such a major player in the world wide market that suppliers

compete against themselves to get their business. Last year alone Starbucks

purchased 312 million pounds of coffee (2% of the worlds coffee production)

from 27 different countries. Starbucks also purchased over three million pounds

of tea and 12.4 million pounds of coca from countries all over the globe. These

commodities have almost an endless supply of buyers, most of which are looking

for the cheapest price. The suppliers are looking for high volume buyers that are

not necessarily looking for the cheapest price. This is what makes Starbucks so

appealing. If the quality is high enough Starbucks is willing to purchase an

extremely high volume.

With purchases of such a high volume suppliers can not afford to refuse

an order from Starbucks. Being chosen as a supplier for Starbucks can mean the

difference between turning a profit for the year and taking a loss on the year.

Starbucks puts a great amount of pressure on the suppliers in that they can not

sacrifice quality while still keeping their costs relatively low. Suppliers also

compete for Starbucks because they know they are going to sell a vast quantity

at a premium price.

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Value Chain Analysis

Starbucks follows a differentiation strategy when it comes to creating a

competitive advantage. This strategy allows them to be seen as unique by

customers, compared to their competitors. They key to Starbucks continued

success is that they produce a product of a much superior quality then that of

their competitors while continuing to offer a variety of products that separate

themselves from their competitors. They understand that customers place value

on the image offered by drinking Starbucks coffee, and are willing to pay a

higher price for the name. This investment in brand image has been a priority of

Starbucks ever since its inception. This brand image goes above and beyond

just the actual coffee but to the entire Starbucks “experience”. Howard Schultz,

the chairman of Starbucks, said that, “You get more than the finest coffee when

you visit a Starbucks—you get great people, first-rate music and a comfortable

and upbeat meeting place. We establish the value of buying a product at

Starbucks by our uncompromising quality and by building a personal relationship

with each of our customers. Starbucks is rekindling America’s love affair with

coffee, bringing romance and fresh flavor back to the brew.” Starbucks has

continued to invest researching and developing new products to offer its

consumers.

Firm Competitive Advantage Analysis

Starbucks has been able to successfully match their core competencies

with the key success factors in order to become the world’s most recognizable

brand of coffee. It has been able to differentiate itself from other coffee houses

through its continuous movement towards diversification. It has unique flavors

that are not offered anywhere else that keep customers coming back. It has

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maintained a commitment to quality in that it is willing to pay a higher price for

higher quality product. The quality is so superior to that of its competitors that

people are willing to pay much higher prices for essentially the same product.

This also says that Starbucks’ investment in its brand image has resulted in a

very loyal customer base. While some people feel that Starbucks is an “evil

empire” that bullies local cafés out of business these people are vastly

outnumbered by the people who go out of their way each morning to just so

they can get their Starbucks.

In the future Starbucks will continue to lead the coffee serving industry as

it becomes more popular throughout the world. Their differentiation will without

a doubt continue as they promote new ideas and continue to provide the

customers with a unique experience. With their current name recognition they

should have no trouble staying ahead of their few competitors as they continue

to expand overseas and into growing markets such as China. The competitive

advantage that Starbucks has established will be only strengthened as they

expand into new markets throughout the world.

Accounting Analysis

Key Accounting Policies

In order to appropriately interpret the financial statements of a

differentiated company such as Starbucks you must first understand their

underlying accounting polices. Having accurate financial statements makes it

easier for investors to value and determine whether or not to invest in Starbucks.

The main goal of doing financial statement analysis is to determine the success

factors and risks that are managed by the firm.

Initially, it is important that we realize that Starbucks consolidated

financial statements only include the subsidiaries which are owned by the

company as well as their other companies in which they have significant

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influence over. In addition Starbucks fiscal year ends on the Sunday closest to

September 30th, which allows for the high revenue from the holiday season to be

recognized within one financial statement.

Operating Leases

Starbucks record all of their leases on retail stores, roasting and

distribution facilities, and office space under operating leases. The company

records minimum rental expenses on a straight-line basis in order to recognize

incentives and premiums as they occur. Starbucks begins the amortization

process on the date of initial possession, which is when the Company enters the

space. The leasing procedure that Starbuck’s implements significantly affects the

result of the financial statements, compared to alternative ways to record

facilities.

Goodwill and Intangible Assets

Goodwill is another key accounting principle that contributes to Starbucks

success. This is because in the retail industry brand recognition and customer

loyalty are very valuable to obtain and retain. Starbucks has acquired many

facilities and companies that have increased their goodwill, and potentially their

bottom line.

Advertising Expenses

Since Starbucks is considered a consumer good firm, marketing and brand

image are important to their company’s success. This means that advertising

expenses are a huge part of the income statement. Starbucks expenses these

costs as they are incurred, and is recorded in “Store operating expenses”, and

“General and administrative expenses”.

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Stock Options

Employee stock options outstanding are a significant percentage of the

overall stock outstanding. This is key factor because in valuing the company an

investor must consider the number of stock options that could be exercised. This

is important because as an investor you do not want a lot of stock selling at a

discounted rate and as a result diluting the market.

Inventory

It is also important to realize how Starbucks records their inventory on

their consolidated financial statements. Since they sell products, not services,

they have a large inventory, which they record at the lower of cost or market. It

is also crucial how a firm records and depreciates its inventory, and can give

investors wrong information if not done correctly.

Degree of Accounting Flexibility Starbucks as a firm has some accounting flexibility in measuring their key

success factors and risks. This flexibility allows Starbucks to manage its reported

numbers in a way that allows their accounting data to be informative and true to

how their company is doing. Starbucks, like most other companies in the United

States, must adhere to standard accounting policies and conventions. With all of

the new SEC regulations, companies have less room to move around numbers in

their financial statements in a way to benefit them.

With respect to the company’s inventory, Starbucks can implement

moving average cost method, last-in-first-out method, or the first-in-first-out

method. All of these methods produce variant outcomes that can either benefit

or handicap the financial statements of the firm. Also, every firm has a choice

on how the want to amortize Goodwill over the period. They can write-off the

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Goodwill over forty years or take a more conservative approach and write it off

over a shorter time period. Starbucks also has the choice of using operating

leases for their buildings or they can capitalize them as assets and liabilities.

This choice can greatly impact the way an investor views the company’s value

because of the way it allocates the involved overhead costs. Advertising on the

other hand has very little accounting flexibility due to the fact that GAAP requires

all marketing outlays to be recorded as expenses when incurred. This could

effect the year to year statements because income could be diluted in years

where they emphasize marketing.

With the use of flexibility, firms can manipulate their financials in a way to

improve their appearance. This can be both beneficial and detrimental for

potential investors. Firms in some cases could choose not to disclose some

valuable information; which could in turn mislead investors. These manipulations

are what causes a firm to be under or overvalued by the investor, and can have

a huge effect on the firm.

Accounting Strategy

When dealing with operating leases Starbucks takes an aggressive

approach buy recording their buildings as operating leases rather than assets.

This policy results in a liability distortion resulting in off balance sheet debt. This

can possibly mislead investors by hiding liabilities resulting in poor investing

choices through non-representative ratios.

Goodwill is expensed by recording the excess of fair value on the

acquirer’s balance sheet. They divide their goodwill into indefinite and definite

life and then amortize the definite life over a six year time span. While doing this

they have a much larger percentage of indefinite lived goodwill which is a rather

aggressive assumption, resulting in inflated assets. However, Starbucks is more

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limited in their aggression than other companies who use the pooling of interest

method when dealing with good will.

In compliance with GAAP, the advertising expenses are excluded from the

balance sheet because benefits associated with advertising are too uncertain.

Although this is not an accounting choice it could lead to unpreventable

deception which would be eliminated through more aggressive accounting

strategies. With 72.5 Million stock options yet to be exercised and with 768.4

Million shares outstanding these uncalled stock options represent a considerable

percentage and must be considered when evaluating the company. This should

be taken into account when investors consider investing because if these options

are called then stockholder’s percentage of equity would be diluted. Many

retailing companies can use inventory processes to their advantage but

Starbucks takes a moderate approach by using the average cost method to

accounting.

In conclusion Starbucks takes a moderate to slightly aggressive approach

to their accounting strategies. With the exception of the operating leases

Starbucks is fairly transparent in revealing their financial statements.

Quality of Disclosure

The Footnotes were not sufficient in providing disclosures to assess the

firm’s business strategy and explaining key accounting policies. The footnotes

did describe many financial statement items such as cash and cash equivalents,

allowance for doubtful accounts, property, plant and equipment, etc.

The Management Discussion and Analysis of Financial Conditions and

Results of Operations section of the 10-K sufficiently explains Starbucks’ current

performance. Also the report describes the increase in earnings. Revenues are

growing due to the increase of new stores opening in the United States and in

other countries. This section shows a table comparing the Starbucks’

Consolidated Statements of Earnings and Liquidity and Capital Resources for

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2004 and 2005 at fiscal year end. This table breaks down each item and

describes why each increased between those years. Operating segments are the

business segments that are focused on in the 10-K. The 10-K does not reflect

any bad news or hardly any poor performance that has occurred. However,

footnotes do give a list of how events regarding the operating segment could

lead to a declining financial performance. Starbucks’ is a growing company and

revenues do increase each year, but this section mainly shows all the increases

of the statements and gives some explanation on why certain items decreased.

The following chart describes the ratios of sales manipulation diagnostics for the

Starbucks Coffee Company.

Sales Manipulation Diagnostic 2001 2002 2003 2004 2005

Net Sales/Cash from Sales .992 .998 .998 .995 .992 Net Sales/Net Accounts Receivable 29.29 33.71 35.61 37.74 33.39

Net Sales/Unearned Revenues 98.41 77.82 55.47 43.62 36.39 Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A Net Sales/Inventory 11.97 12.50 11.88 12.53 11.66

These ratios show the performance of Net Sales to certain assets and

liabilities the company has represented in their financial statements.

Cash from Sales consists of Sales +/- the decrease/increase of Accounts

Receivable. Each year, Cash provided/ (used) by changes in operating assets

specifically Accounts Receivable were at a decrease. This is the reason why the

ratio is below one because Cash from Sales is greater than Sales. The Net

Sales/Net Accounts Receivable ratio fluctuated throughout the years. Sales

increased substantially each year as Accounts Receivable only increased slightly.

The Net Sales/Unearned Revenue ratio consistently decreased through the years.

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There is not any information given for the Net Sales/Warranty Liabilities because

“the company establishes an accrual for estimated warranty costs at the time of

sale, based on historical experience.”1 Both components of the Net

Sales/Inventory ratio increased each year. In 2001, 2003, 2005, the Inventory

and Sales amounts were very close to one another, causing a slight decrease in

the ratio number compared to 2002 and 2004.

The following chart describes the ratios of expense manipulation diagnostics for

the Starbucks Coffee Company.

Expense Manipulation Diagnostic 2001 2002 2003 2004 2005

Sales/Assets 1.43 1.49 1.49 1.56 1.81 CFFO/OI .49 .068 .33 .740 .083 CFFO/NOA .1015 .0014 .08 .123 .027 Total Accruals/Change in Sales .48 .44 .47 .35 .51 Pension Expense/SG&A N/A N/A N/A N/A N/A Other Employment Expenses/SG&A N/A N/A N/A N/A N/A

The Net Sales/Assets ratio improved each year because both the Sales

and assets amounts maintained a steady increasing pace. The change in Cash

Flow from Operating Activities/Operating Income ratio is very inconsistent

because the change in CFFO amounts fluctuated so much during those years.

Those amounts for CFFO are: 137,731,000; 21,380,000; 138,433,000;

242,419,000; 65,071,000 from 2001-2005, respectively. The Cash flow from

Operating Activities/Net Operating Assets stayed mainly consistent through out

the five years. Net Operating Assets are calculated by adding Inventory and

Plant, Property, and Equipment. Two of the ratios could not be calculated

because Pension Expense and Other Employment Expenses were not listed on

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any financial statements during any of the five years. Each item may be included

in another account such as Other Operating Expenses but it is not verified in the

10-K.

Potential “Red Flags”

In performing our Sales and Expense Manipulation Diagnostic, we were

able to find a few potential “red flags.” The footnotes did not supply sufficient

explanations of the firm’s business strategies, nor did it provide certain financial

statement items. Most items, such as net sales/cash from sales ratio, showed

similar numbers over the past five years. Potential “red flags” could be the fact

that the firm failed to provide pension expense and other employment expenses

on the financial statements during the past five years. One more item that

raised suspicion was the cash flow from operating activities/operating income

ratio. It was very inconsistent over the past five years. Looking at the financial

statements, we can see the large fluctuations in the CFFO. Due to the fact that

the footnotes did not supply us with the company’s business strategy, we are

unable to determine what might have caused such dramatic changes. One such

instance may be due to the fact that during years with high CFFO, Starbucks

opened new stores, making their CFFO larger. The most evident “red flag” we

discovered was that Starbucks does not capitalize their leases. This is a

distortion because potential investors do not get to see the overall picture of

what Starbucks financials look like. Therefore, there liabilities are substantially a

lot lower than they really should be. This results in most of the ratios being

wrong and therefore misleading to investors.

Undo Accounting Distortions

After we identified that Starbucks does not capitalize their operating

leases, we had to figure out a way to undo this accounting distortion. We

started by taking the disclosed financial statements and then altering them to

include their operating leases. First we found the Present Value of the total of all

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the future operating lease expenses from the 10K. These numbers from the 10K

were discounted back to the beginning year. They were then summed together

and divided by 20 and then we multiplied that number by 6%, which was our

growth rate. After we found these numbers for each year, we plugged them into

the Income Statement and the Balance Sheet. On the Income Statement, we

added the Present Value summed number to the Depreciation and Amortization

expense for each year. After we did that, we added the Present Value times 6%

numbers to the Interest and other income line for each year. On the Starbucks

Balance Sheet we added the sum of all the Present Values for a year to the

previous number given under Long-term debt, and then subtracted from that

number the summed number that we used previously. We then did the exact

same thing to the Property, Plant and Equipment line; this was in order to make

Assets equal to Liabilities and Shareholders Equity. This resulted in both Total

Assets and Total Liabilities & Shareholders Equity increasing by the same

amount. After we accounted for our operating leases on our Income Statement

the net earnings also increased. The aftermath of these alterations were that

many of our ratios also changed dramatically. Therefore, accounting for

Starbucks operating leases changed the financial statements in many areas.

After we undid this accounting distortion we were able to see the true value of

the company more clearly.

Financial Ratio Analysis

The purpose of any kind of financial analysis is to asses the overall value

of the company with respect to previous earnings as well as predicting the future

value of the firm. Many different techniques can be used in determining the

value of the firm. The fist step in the process of valuing Starbucks was

capitalizing all of the operating leases to form a clear picture of the total liabilities

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of the company. The ratio analysis will produce actual numbers that we can

compare to previous years.

In this section, the financial ratios of the Starbucks Company will be

calculated and evaluated. The financial ratios are divided into three sections;

liquidity, profitability, and capital structure. The liquidity section shows how fast

assets can be turned into cash and cash equivalents. The profitability section

evaluates the overall operating efficiency, asset productivity, return on assets,

and return on equity of the company. The capital structure section shows how

financing sources are used to obtain assets. The capital structure section is also

focused around the debt and equity parts of the balance sheet and the cash flow

from operations. These ratios are important because they help in the evaluation

of the company’s performance during the last five years. The ratios aid in the

comparison of the balance sheet, income statement, and statement of cash

flows. They also show trends throughout the financial statements and give an

arithmetic analysis of why the ratios increase and decrease throughout the years.

These trends allow for more accurate forecasting of the future performance of

the firm. It also helps in showing us how reasonable our forecasts are.

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Capitalized Lease Ratios

After Capitalization

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

LIQUIDITY RATIOS

Current Ratio 1.55 1.67 1.52 1.81 0.99 1.06 1.34 1.36 1.38 1.41 1.43 1.46 1.49 1.51 1.54

Quick Asset Ratio 0.81 0.92 0.76 1.06 0.41 0.58 0.68 0.69 0.70 0.71 0.72 0.74 0.75 0.76 0.78

EFFICIENCY RATIOS

Accounts Receivable Turnover 29.29 33.71 35.61 37.76 33.39 39.17 49.84 49.84 49.84 48.54 47.27 45.22 43.25 41.37 39.57

Days' Receivables 12.46 10.83 10.25 9.67 10.93 9.32 7.32 7.32 7.32 7.52 7.72 8.07 8.44 8.82 9.22

Inventory Turnover 4.28 4.37 4.21 4.51 4.15 6.20 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25

Days' Inventory 85.35 83.59 86.70 80.85 88.05 58.83 85.88 85.88 85.88 85.88 85.88 85.88 85.88 85.88 85.88

Working Capital Turnover 12.58 10.61 12.92 8.76 -360.62 95.38 25.72 24.46 23.33 21.74 20.31 18.68 17.21 15.89 14.70

PROFITABILITY RATIOS

Gross Profit Margin 64.28% 65.06% 64.58% 63.96% 64.44% 63.75% 63.75% 63.75% 63.75% 63.75% 63.75% 63.75% 63.75% 63.75% 63.75%

Operating Expense Ratio 42.29% 44.10% 43.32% 42.80% 42.71% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83%

Net Profit Margin 9.62% 8.87% 9.59% 9.93% 10.40% 9.28% 9.28% 9.28% 9.28% 9.28% 9.28% 9.28% 9.28% 9.28% 9.28%

Asset Turnover 0.85 0.86 0.89 0.96 1.05 1.24 1.30 1.30 1.30 1.26 1.23 1.18 1.12 1.08 1.03

Return on Assets 8.22% 7.64% 8.56% 9.54% 10.96% 11.52% 12.02% 12.02% 12.02% 11.71% 11.40% 10.91% 10.43% 9.98% 9.54%

Return on Equity 18.53% 16.94% 18.76% 21.28% 31.68% 26.41% 26.71% 26.71% 26.71% 26.02% 25.34% 24.23% 23.18% 22.17% 21.21%

CAPITAL STRUCTURE

Debt to Equity Ratio 1.25 1.22 1.19 1.23 1.89 1.47 1.22 1.22 1.21 1.20 1.20 1.19 1.19 1.18 1.18

Times Interest Earned 25.30 30.09 34.46 37.34 41.50

Debt Service Margin 685.34 867.77 1189.11 1256.61 2065.63

IGR 18.53% 16.94% 18.76% 21.28% 31.68% 26.41% 26.71% 26.71% 26.71% 26.02% 25.34% 24.23% 23.18% 22.17% 21.21%

SGR 41.69% 37.61% 41.08% 47.45% 91.56% 40.68% 41.14% 41.14% 41.14% 40.06% 39.02% 37.32% 35.70% 34.15% 32.66%

23

Operating Lease Ratios

With Operating Leases Forecast

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

LIQUIDITY RATIOS

Current Ratio 1.55 1.67 1.52 1.81 0.99 1.06 1.30 1.24 1.17 1.12 1.06 1.01 0.96 0.91 0.87

Quick Asset Ratio 0.81 0.92 0.76 1.06 0.41 0.58 0.66 0.63 0.60 0.57 0.54 0.51 0.49 0.46 0.44

EFFICIENCY RATIOS

Accounts Receivable Turnover 29.29 33.71 35.61 37.76 33.39 39.17 48.40 48.40 48.40 48.40 47.14 45.09 43.13 41.25 39.46

Days' Receivables 12.46 10.83 10.25 9.67 10.93 9.32 7.54 7.54 7.54 7.54 7.74 8.09 8.46 8.85 9.25

Inventory Turnover 5.03 5.13 4.90 5.18 4.77 6.96 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00

Days' Inventory 72.57 71.15 74.45 70.40 76.54 52.47 73.00 73.00 73.00 73.00 73.00 73.00 73.00 73.00 73.00

Working Capital Turnover 12.58 10.61 12.92 8.76 -360.62 95.38 27.00 32.69 42.01 60.01 106.45 749.76 -125.92 -53.84 -32.56

PROFITABILITY RATIOS

Gross Profit Margin 57.99% 58.95% 58.74% 58.61% 59.10% 59.36% 59.36% 59.36% 59.36% 59.36% 59.36% 59.36% 59.36% 59.36% 59.36%

Operating Expense Ratio 42.29% 44.10% 43.32% 42.80% 42.71% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83% 43.83%

Net Profit Margin 6.81% 6.47% 6.51% 7.35% 7.76% 7.65% 7.65% 7.65% 7.65% 7.65% 7.65% 7.65% 7.65% 7.65% 7.65%

Asset Turnover 1.43 1.49 1.49 1.56 1.81 2.09 2.18 2.18 2.18 2.18 2.12 2.03 1.94 1.86 1.78

Return on Assets 9.77% 9.60% 9.72% 11.49% 14.07% 15.96% 16.66% 16.66% 16.66% 16.66% 16.22% 15.52% 14.84% 14.20% 13.58%

Return on Equity 13.11% 12.34% 12.74% 15.75% 23.65% 26.53% 22.21% 22.21% 22.21% 22.21% 21.63% 20.69% 19.79% 18.93% 18.11%

CAPITAL STRUCTURE ANALYSIS

Debt to Equity Ratio 0.30 0.29 0.31 0.37 0.68 0.66

Times Interest Earned 648.66 1044.02 1588.11 1639.42 736.43 116.63

Debt Service Margin 685.34 867.77 1189.11 1256.61 2065.63 0.00

IGR 13.11% 12.34% 12.74% 15.75% 23.65% 26.53% 22.21% 22.21% 22.21% 22.21% 21.63% 20.69% 19.79% 18.93% 18.11%

SGR 13.11% 12.34% 12.74% 15.75% 23.65% 26.53% 22.21% 22.21% 22.21% 22.21% 21.63% 20.69% 19.79% 18.93% 18.11%

Trend Analysis

The goal of financial analysis is to assess the performance of a firm in the

context of its stated goal and strategy. It involves assessing how various line

items in a firm’s financial statements relate to one another. There are three

different types of ratios liquidity, efficiency, and profitability, all of which tell us

different things about the firm.

24

Liquidity Ratios

The Liquidity ratios allow analysts to estimate the liquidity of the firm.

These ratios are also often important in the credit rating that a firm will receive

from a bank because it is a good reflection of a firm ability to repay a loan. As

you can see the liquidity ratios do not change when we capitalize the leases so

we do not have to account for this change. The current ratio indicates that from

2001-2005 current liabilities grew causing the current ratio to decrease from 1.55

to .99. This simply tells us that Starbucks current liabilities are increasing at a

higher rate than their current assets forcing the ratio down. The quick assets

ratio declined as well, which indicates the increase in liabilities. The main cause

of the variation in this ratio was an unusual and significant increase in short term

borrowings. We do not however anticipate these borrowings to continue into the

future.

Efficiency Ratios

Efficiency ratios allow analysts to see how well a company turns over

their inventory and receivables. In Starbucks case there is very little variation

from year to year on any of these ratios. The accounts receivable turnover grew

from 29.29 in 2001 to 33.39 in 2005. This growth could indicate an increase in

non-credit sales but it definitely tells us that they are getting their money faster

as you can see by the decline in the day’s receivable ratio. Inventory turnover

stayed rather constant over this period which shows that the company probably

not focused on becoming more efficient in this category. The working capital

turnover decreased between 2000 and 2005. In 2005, current liabilities exceed

current assets, driving the ratio up and making it negative. Therefore the ratio

for 2005 can not be compared to the others, the liabilities have increased

uncharacteristically due to the fact that Starbucks used short-term borrowing for

financing and they had not done this before.

25

Profitability Ratios

Profitability ratios are often used by investors to estimate how profitable a

company is. These ratios take many different aspects of the financial statements

and compare them showing returns both assets and equity. The gross profit

margin ratio stayed and the operating expense ratios both stayed constant over

the last five years. Net profit margin increased from 2001-2005 due to an

increase in net income this could also be attributed to the fact that Starbuck’s

expansion has brought on more loyal customers creating more efficiency with

economies of scale. Asset turnover increased from .84 to 1.03 and as a result

the ROA also increased over this time. This is because of an increase in sales.

The return on equity ratio increased from 18.53% in 2001 to 31.68% in 2005.

This increase is due to the increase in net income but we expect that this ratio

will level off in the future down to a more reasonable percentage. All of these

ratios are being viewed after the capitalization of the leases

Capital Structure Ratios

The debt to equity ratio decreased from 2001-2005. This increase in

2005 is once again due to the increase in short-term liabilities. The times

interest earned ratio increased from 25.30 in 2001 to 41.50 in 2005. This

increase could be due to an increase in NBIT. The debt service margin increased

from 2001-2004. This increase is probably because of an increase in operating

cash flows.

Ratio Changes after Capitalization

Capitalizing the operating leases caused a few significant changes in the

diagnostic ratios. These changes were expected and usually should provide a

more accurate picture of Starbucks performance. The Inventory turnover ratio

decreased on average of 0.698 per year. This can be attributed to the fact that

26

the Operating Lease expense was included in the Cost of Goods Sold. This was

not good disclosure on Starbucks part. Since they have been expensed we now

have a more accurate picture of the company’s assets. This decrease in asset

turnover is the reason for the increase in the inventory holding period. When

Starbucks had their operating leases the depreciation expense was subtracted

from the gross profit and when the leases were capitalized this expense

transferred to the depreciation and amortization portion of the balance sheet.

This accounts for the rise in the gross profit margin. This removal of

depreciation expense also accounts for the rise in net profit margin and the

return on equity as well. Capitalizing the lease increased Starbucks’ assets and

liabilities when it was added to the property, plant, and equipment balance. This

accounts for decrease in both the asset turnover and return on assets as well as

causing a significant increase in their debt to equity ratio. The increase in debt

to equity and their subsequent rise in their credit risk would be an important

factor in Starbucks decision for not capitalizing their operating leases. The

increase in net income was offset by the vast increase in interest expense which

caused a decrease in their times interest earned ratio. Overall these are the only

ratios that were significantly changed by the capitalization of the leases. We

believe that the post-capitalized lease ratios provide much more accurate ratios

that we can use in valuing this company.

After performing a ratio analysis on Starbuck’s financial statements we

found a continuous growth trend. We were unable to compare the ratios and

financial statements to competitors due to the fact that there are not any other

large companies in the same business. This is due to the fact that most of the

other similar places focus primarily on food while Starbucks focuses on beverage

sales. Overall we concludes that performance wise they are doing well, for

instance, the net profit margin is staying rather consistent along with their return

on assets. We will be using a combination of these ratios and average growth

percentages in order to forecast Starbuck’s financials for the next ten years.

27

Financial Statement Forecasts

The first step in forecasting the Income Statement was to find the

average increase in sales over the past five years (20%) and estimate how it will

grow over the next five years. This was difficult to do since we do not believe

that Starbucks will be able to maintain this high growth rate throughout the next

ten year. In estimating the percentages we looked at companies such as Wal-

Mart which had experienced similar growth as a large company. We saw that

their growth leveled off to a sustainable 10% and forecasted our income

statement accordingly. We did this by increasing sales in 2006 and 2007 by

20%; this is because we believe that this level of increases can be maintained for

at least two more years. We then estimated the growth to go to 15% for the

next two years, 12% for one year, and 10% for the remaining three years.

These estimates, although possibly conservative, seem reasonable for a company

such as Starbucks. In forecasting the income statement we increased all of the

aspects by the same percentage due to the fact that over the last five years the

percentages in relation to sales have remained consistent to one another. We

believe that this is a reasonable approach in forecasting the financial statements.

When forecasting the balance sheet, most items were calculated as a

percentage of total assets or total liabilities and shareholders equity. In order to

get the percentage we estimated the percentages of the last five years for every

item using the common sized balance sheet. In order to get total assets we took

an average of total assets for the last five years which equaled a growth rate of

15%. To forecast inventory, we found the average inventory ratio by averaging

the inventory turnover ratio for the last five years and divided that amount

(4.25%) from the predicted cost of goods sold. Regarding the No Trend items

we could not draw any reasonable conclusions from the common sized balance

sheet in order to forecast out.

28

We currently have the first three quarters (10-Q) for 2006. In order to

predict the estimated fourth quarter for 2006 we averaged the first three

quarters and multiplied by four. This was done because we determined there

was no seasonality.

There are a few limitations, strengths, and weaknesses when evaluating

the forecasted financial statements. First, in many items of the balance sheet,

there were no trends when forecasting out ten years. This is because there

were no consistent trends throughout those particular percentages. Second,

Starbucks does not pay dividends which in turn affect Sustainable Growth Rate

and Internal Growth Rate. Since we had to capitalize their operating leases,

many of the numbers were estimated through our own educational reasoning.

One of the strengths is that we get consistent percentages on the common sized

income statement and balance sheet.

Finally, in forecasting our cash flows we only felt as though we could

reasonably forecasts the operating cash flows. This was due to the fact that

there were not any trends in the financing or investing activities. We simply

forecasted the operating cash flows by taking the EBIT off of the income

statement because we noticed a direct correlation between these two items over

the past five years.

In conclusion, we are anticipating that Starbucks will continue to grow and

we do not anticipate a slow down. However we do not believe that they can

continue to increase their sales at a high rate consistently and as a result we

have estimated that their sales increases will decrease. We also believe that

Starbucks business strategy will continue into the future.

29

Firm Valuation

In valuing firms there are many important factors that we must first

estimate. These factors include the costs of debt and cost of equity, which both

also allow us to estimate the weighted average cost of capital.

Costs of Debt

In estimating the costs of capital we must first find estimated costs of

debt. We do this by weighting each of the liability categories and assigning and

interest rate to each one. Most of these interest rates are found in the 10-K but

some must be estimated and derived. A significant contributor to our costs of

debt is the plant property and equipment. This is important because the interest

rate that we estimated for this was 6% and therefore this has significant

implications in out costs of capital; therefore a large portion of our costs of debt

is being estimated due to our previous assumptions. After weighting all of our

liabilities we arrive at a cost of debt of 5.70%. Our tax rate in this case is 37.9%

therefore our after tax costs of debt is only 3.47%. We feel as though this is a

reasonable estimate for out costs of debt.

Costs of Equity

When we estimated the costs of debt we took many different factors into

consideration. First of all we compared the Starbucks returns over the past five

years to the returns seen in the S&P 500. This allowed us to find the appropriate

beta to use in our CAPM model. We found the best beta by picking the

regression that yielded us the highest R-square. The regressions were run

comparing Starbucks returns to the market premium which was found with the

market returns less the risk free rate. We used a variety of risk free rates with a

variation of maturities ranging from 6 months to 10 years. The results of these

regressions are seen in the table. This allowed us to run 16 separate regressions

30

and after doing this we found that the most appropriate beta was 1.67 giving us

a Ke of 16.3%. The cost of equity (Ke) was estimated by plugging our beta into

the CAPM model which yielded us the cost of equity.

Months Beta R^2 Ke 10 Year 60 0.5230 0.05779 0.083 48 0.3608 0.01808 0.071 36 1.1748 0.11543 0.128 24 1.6685 0.20472 0.1635 Year 60 0.5245 0.05827 0.084 48 0.3643 0.01851 0.072 36 1.1820 0.11698 0.130 24 1.6645 0.20443 0.1632 Year 60 0.5272 0.05881 0.085 48 0.3677 0.01891 0.074 36 1.1895 0.11850 0.131 24 1.6604 0.20342 0.1646 Month 60 0.5295 0.05914 0.086 48 0.3686 0.01900 0.075 36 1.1933 0.11904 0.133 24 1.6587 0.20242 0.164

WACC

The weighted average costs of capital were found using our cost of equity

and cost of debt. The WACC is estimated by weighting the total debt and total

equity and using our estimates to calculate the WACC. After doing this we find

that our WACC is 8.04%. This is the last percentage that we need in order to

use the valuation models. These valuation models we believe will be accurate

based on all of our carefully calculated estimates.

Credit Risks

The Altman Z-Score is a model that is often used to find the credit

worthiness of a company. (See Appendix) This method assigns values to many

different ratios and allows us to come up with a number that reflects a

31

company’s credit worthiness. According to this model a value of less than 1.81

implies a high risk of bankruptcy, a value ranging from 1.81 to 2.67 implies a

high credit risks, and a value above 2.68 implies a good credit risks. In

Starbucks case we see that over the past five years the Z-Score has been

increasing and relatively high suggesting that Starbucks would probably be able

to borrow money at a low interest rate and that they are credit worthy. This Z-

Score is calculated using the financial statements with the capitalized leases and

therefore these scores are much lower than they would be using the regular

financial statements which prove how credit worthy Starbucks really is.

Z-Score WC/TA RE/TA EBIT/TA MVE/BVL S/TA

2001 3.72 0.081551 0.266354 0.386067156 2.264524 0.71931

2002 4.13 0.097348 0.2935355 0.361073767 2.644421 0.730758

2003 4.57 0.082867 0.3279622 0.403101508 2.999928 0.755462

2004 5.77 0.131707 0.3671946 0.453698135 4.004218 0.809119

2005 5.28 -0.00351 0.4494108 0.526701075 3.41006 0.892486

Intrinsic Valuations

In conducting our intrinsic valuation we use three different types of

valuations methods. They include residual income, discounted cash flows, and

abnormal earnings growth models. These are our only three valuation methods

due to the fact that our company does not pay dividends we are unable to use

the discounted dividends method. Also we cannot use the method of

comparables to value Starbucks because we have found no true competitors that

we would be able to accurately compare Starbucks to.

Residual Income Valuation

There are many steps to calculating the Residual Income Valuation model.

First, the beginning book value of equity is added to earnings per share then

dividends paid are subtracted out to get the ending value of equity (Starbucks

32

does not pay dividends, so it would be excluded from this formula). The ending

value of equity of the previous year is the beginning book value of equity used in

the next year. The estimated amount of Ke used in this valuation is .163 or

16.3%. Normal income is the beginning book value of equity multiplied by Ke.

Residual Income is calculated by subtracting the earnings per share of the next

year by normal income of the previous year. The PV factor is calculated by using

the equation 1/ ((1+Ke)t), where t is the number of years used for that specific

calculation. The present value of residual income is calculated by multiplying the

residual income by the present value factor. The total present value of annual

residual income is the sum of the present value of residual income from years

2006-2015. The terminal year is the 10th year which is 1015. The continuing

(terminal) value perpetuity is calculated by dividing the terminal year present

value of residual income by the subtraction of Ke minus the logical test for growth

in perpetuity. To find the present value of terminal value perpetuity, the

continuing (terminal) value perpetuity is multiplied by the present value factor of

the 9th year or 2014. To calculate the estimated price per share (end of 2005)

the total present value of annual residual income is added to present value of

terminal value perpetuity and bps (book value equity per share). This is a

summary of the calculations found in Appendix: 1.8. The sensitivity analysis of

the residual income valuation method will now be discussed.

Sensitivity Analysis

Ke g 0.103 0.113 0.123 0.133 0.143 0.153 0.163

0 $9.46 $8.35 $7.46 $6.73 $6.12 $5.60 $5.14 0.01 $9.60 $8.43 $7.50 $6.75 $6.13 $5.59 $5.14 0.02 $9.77 $8.52 $7.55 $6.77 $6.13 $5.59 $5.13 0.03 $9.99 $8.64 $7.61 $6.80 $6.14 $5.59 $5.13 0.04 $10.27 $8.78 $7.68 $6.83 $6.15 $5.59 $5.12 0.05 $10.67 $8.97 $7.77 $6.87 $6.16 $5.59 $5.11

The observed share price at the end of 2005 is $38.26. At a cost of equity

(Ke) of 16.3% and a growth of .03, then the estimated price per share at the end

of 2005 is $5.13. This shows that Starbucks is extremely overvalued by an

33

amount of $33.13 when comparing the observed and estimated prices. This is

applying our estimated costs of equity and even if we take a much more liberal

approach at 10.3% we still do not get a number anywhere close to the market

value of the stock.

AEG Valuation

The calculations of Abnormal Earnings Growth and Residual Income

Valuation Models are similar. It is very easy to calculate abnormal earnings

growth, but to find the value is a longer process. AEG is calculated by

subtracting normal earnings from cumulative dividend earnings. The equation to

calculate normal earnings is EPS x (1 + Ke). The present value factor equation is

1/ ((1+Ke)t). In order to get present value AEG, AEG and the present value

factor are multiplied together. The core eps is the earnings per share of the

initial year which is this case is 2005. The total present value of AEG is the sum

of present value of AEG for all the years (2007-2017). The continuing (terminal)

value is calculated by dividing the AEG of the terminal year by the subtraction of

Ke minus growth. The present value of the terminal year is calculated by

multiplying the continuing (terminal) value by the present value factor of the 8th

year or 2014. The total present value of AEG equals the sum of the total present

value of AEG plus the present value of terminal value. To get the total average

EPS perpetuity, the core EPS is added to the total present value of AEG. The

capitalization rate (perpetuity) is the amount of Ke. The value per share is the

total average EPS perpetuity divided by the capitalization rate. This summarizes

the calculations made in Appendix: 1.7. The sensitivity analysis of the abnormal

earnings growth valuation method will now be discussed.

By using a Ke of .163 and a growth of zero, the value per share comes out

to be $2.69. By comparing the actual price per share of $38.26 to the value per

share of $2.69, it shows a drastically overvalued company. Starbucks is

overvalued by $35.57 when using the abnormal growth valuation method. This

34

method shows an even lower estimated value per share that when using the

residual income valuation method. Therefore we once again can conclude that

based on our forecasts we do not believe that Starbucks is reasonably valued.


g 0 0.05 0.08 0.1

Ke 0.133 $4.99 $3.97 $2.44 ($0.13) 0.143 $4.02 $3.07 $1.78 ($0.09) 0.153 $3.28 $2.42 $1.34 ($0.06) 0.163 $2.69 $1.93 $1.03 ($0.04) 0.173 $2.23 $1.56 $0.81 ($0.03)

Long Run ROE Valuation

The long run ROE valuation does not work for Starbucks. This is due to

the fact that the Return on Equity is equal to the Growth in book value and this

does not provide us with a value for our stock. This is due to the fact that when

you calculate the value of the stock you are multiplying the book value per share

times the difference in ROE and Ke divided by the difference in Ke and Book

value growth. This leaves us with a value of negative one since these two

numbers are equal. When we multiply this by the current book value and add it

to the current book value of the stock we are always left with a stock value of

zero. Therefore this model does not provide us with any useful information in

how accurately Starbucks is valued.

Cash Flow Valuation

The discounted free cash flow valuation is a very simple valuation model.

It is simply the present value of all future cash flows per share. In discounting

free cash flows we simply take all future cash flows that we have forecasted and

discount them back to the present value. This gives us a price which we then

divide by the number of shares to get the present value. In discounting the cash

35

flows we use our WACC which is 8.04%. This is due to the fact that the

operating cash flows are for the whole firm and so we must use the WACC which

incorporates both the Ke and the Kd. It is obvious by looking at Starbucks

discounted cash flows that this is the only model that we have used that gives us

a price anywhere close to the market value. We cannot however trust this model

entirely because we have only used future operating cash flows in the model.

This is because our investing and financing activities, which have both always

been negative, are impossible to forecasts because there are no historical trends.

By looking at the Sensitivity analysis we see that Starbucks is still overvalued or

accurately valued at our WACC of 8.04%. This is seen even with only the

operating cash flows and therefore we still conclude even by this model that

Starbucks is significantly overvalued at a market price of $38.26.


WACC 38085 0.0304 0.04 0.0504 0.06 0.07 0.08 0.09

g 0 110.54 79.39 60.74 48.37 39.60 33.08 28.06 0.01 158.27 101.49 72.97 55.89 44.55 36.50 30.51 0.02 297.80 145.25 93.24 67.11 51.45 41.04 33.65 0.03 N/A 273.16 133.39 85.73 61.77 47.39 37.84 0.04 N/A N/A 250.76 122.60 78.88 56.88 43.68

36

References 1.http://edgarscan.pwcglobal.com/servlets/RunQuery?goal=wf_next_region&accession=0000891020-05-000350&format=edgarscan&start=119&end=2298#next 2.http://edgarscan.pwcglobal.com/servlets/RunQuery?goal=wf_next_region&accession=0000891020-05-000350&format=edgarscan&start=119&end=2542#next 3.Palepu, Krishna G. Business Analysis & Valuation. Third Edition. © 2004 by South-Western, a division of Thomson Learning™ 4.http://www.starbucks.com 5.http.//www.hoovers.com/starbucks/--ID___15745--//free-co-fin-market.xhtml

37

Appendices

1.1 Balance Sheet Operating Leases 1.2 Income Statement Operating Leases 1.3 Cash Flows Operating Leases 1.4 Balance Sheet Capitalized Leases 1.5 Income Statement Capitalized Leases 1.6 Cash Flows of Operating Leases 1.7 AEG Valuation 1.8 Residual Income Valuation 1.9 Present Value of Cash Flows 1.10 LR ROE Valuation 1.11 Costs of Equity 1.12 Costs of Debt 1.13 WACC 1.14 Z-Scores

STARBUCKS CORP: Balance Sheet (in millions of dollars)

ASSETS 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Current assets: Cash and cash equivalents $ $113.24 $99.68 $200.91 $145.05 $173.81 $251.44 $234.75 $269.97 $310.46 $357.03 $410.58 $472.17 $543.00 $624.45 $718.11

Short-term investments - available-for-sale $101.40 $217.30 $128.91 $483.16 $95.38 $240.25 $298.78 $343.59 $395.13 $454.40 $522.56 $600.95 $691.09 $794.75 $913.96

Short-term investments - trading securities $5.91 $10.36 $20.20 $24.80 $37.85 $46.85 $32.01 $36.81 $42.34 $48.69 $55.99 $64.39 $74.05 $85.15 $97.92

Accounts receivable $90.43 $97.57 $114.45 $140.23 $190.76 $197.77 $192.07 $220.88 $254.01 $292.12 $335.93 $386.32 $444.27 $510.91 $587.55

Inventories $221.25 $263.17 $342.94 $422.66 $546.30 $452.65 $755.69 $869.04 $999.39 $1,149.30 $1,287.22 $1,415.94 $1,557.54 $1,713.29 $1,884.62

Prepaid expenses and other current assets $29.83 $42.35 $55.17 $71.35 $94.43 $85.94 no trend

Deferred income taxes, net $31.87 $42.21 $61.45 $63.65 $70.81 $77.05 no trend

Total current assets $593.9 $772.6 $924.0 $1,350.9 $1,209.3 $1,351.9 $1,493.9 $1,718.0 $1,975.7 $2,272.0 $2,612.8 $3,004.7 $3,455.4 $3,973.8 $4,569.8

Long-term investments -available-for-sale $0.00 $0.00 $136.16 $135.18 $60.48 $55.66 no trend

Equity and other investments $63.10 $102.54 $144.26 $167.74 $201.46 $207.47 $213.41 $245.42 $282.24 $324.57 $373.26 $429.25 $493.63 $567.68 $652.83

Property, plant and equipment, net $1,135.8 $1,265.8 $1,384.9 $1,551.4 $1,842.0 $1,870.8 $2,347.5 $2,699.7 $3,104.6 $3,570.3 $4,105.8 $4,721.7 $5,430.0 $6,244.5 $7,181.1

Other assets $31.87 $43.69 $52.11 $85.56 $72.89 $97.38 no trend

Other intangible assets $0.00 $9.86 $24.94 $26.80 $35.41 $35.94

Goodwill $21.85 $19.90 $63.34 $68.95 $92.47 $92.34 $46.95 $53.99 $62.09 $71.41 $82.12 $94.43 $108.60 $124.89 $143.62

TOTAL ASSETS $ $1,846.5 $2,214.4 $2,729.7 $3,386.5 $3,514.1 $3,711.5 $4,268.2 $4,908.5 $5,644.7 $6,491.4 $7,465.2 $8,584.9 $9,872.7 $11,353.6 $13,056.6

LIABILITIES & SHAREHOLDERS EQUITY

Current liabilities: Accounts payable $127.91 $135.99 $168.98 $199.35 $220.98 $208.59 $256.09 $294.51 $338.68 $389.49 $447.91 $515.10 $592.36 $681.21 $783.40

Accrued compensation and related costs $81.46 $105.90 $152.61 $208.93 $232.35 $229.06 $213.41 $245.42 $282.24 $324.57 $373.26 $429.25 $493.63 $567.68 $652.83

Accrued occupancy costs $35.84 $51.20 $56.18 $29.23 $44.50 $49.05 no trend

Accrued taxes $70.35 $54.24 $54.93 $62.96 $78.29 $181.59 no trend

Short-term borrowings $0.00 $0.00 $0.00 $0.00 $277.00 $105.00 no trend

Other accrued expenses $40.12 $72.29 $101.80 $123.68 $198.08 $187.38 $145.12 $166.89 $191.92 $220.71 $253.82 $291.89 $335.67 $386.02 $443.92

Deferred revenue $26.92 $42.26 $73.48 $121.38 $175.05 $309.29 no trend

Current portion of long-term debt $0.70 $0.71 $0.72 $0.74 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75

Total current liabilities $383.3 $462.6 $608.7 $746.3 $1,227.0 $1,270.7 $1,149.5 $1,390.9 $1,683.0 $2,036.4 $2,464.0 $2,981.5 $3,607.6 $4,365.2 $5,281.9


Long-term debt $5.79 $5.08 $4.35 $3.62 $2.87 $2.68 no trend

Other long-term liabilities $0.41 $1.04 $1.05 $144.68 $193.57 $205.32 no trend

Shareholders equity: Common stock $791.62 $891.04 $959.10 $956.69 $90.97 $61.43 $61.43 $61.43 $61.43 $61.43 $61.43 $61.43 $61.43 $61.43 $61.43

Other additional paid-in-capital $0.00 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39

Retained earnings $589.7 $801.3 $1,069.7 $1,444.9 $1,939.4 $2,113.5 no trend

Accumulated other comprehensive income -$5.41 -$8.58 $14.25 $29.24 $20.91 $18.42 no trend

Total shareholders equity $1,375.9 $1,723.2 $2,082.4 $2,470.2 $2,090.6 $2,232.8 $3,201.2 $3,681.3 $4,233.6 $4,868.6 $5,598.9 $6,438.7 $7,404.5 $8,515.2 $9,792.5

TOTAL LIABILITIES & SHAREHOLDERS $ $1,846.5 $2,214.4 $2,729.7 $3,386.5 $3,514.1 $3,711.5 $4,268.2 $4,908.5 $5,644.7 $6,491.4 $7,465.2 $8,584.9 $9,872.7 $11,353.6 $13,056.6

1.1 Balance Sheet Operating Leases

39

1.2 Income Statement Operating Leases

STARBUCKS CORP: Income Statement

(in millions of dollars)

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Net revenues:

Company-operated retail $ $2,229.59 $2,792.90 $3,449.62 $4,457.38 $5,391.93 $6,549.78 $7,859.74 $9,038.70 $10,394.50 $11,953.68 $13,388.12 $14,726.93 $16,199.62 $17,819.59 $19,601.55

Specialty:

Licensing $0.00 $0.00 $409.55 $565.80 $673.02 $854.04 $1,024.85 $1,178.57 $1,355.36 $1,558.66 $1,745.70 $1,920.27 $2,112.30 $2,323.53 $2,555.88

Foodservice and other $0.00 $0.00 $216.35 $271.07 $304.36 $343.44 $412.13 $473.95 $545.04 $626.80 $702.01 $772.21 $849.44 $934.38 $1,027.82

Total specialty $419.39 $496.00 $625.90 $836.87 $977.37 $1,197.48 $1,436.97 $1,652.52 $1,900.40 $2,185.46 $2,447.71 $2,692.49 $2,961.73 $3,257.91 $3,583.70

Total net revenues $2,648.98 $3,288.91 $4,075.52 $5,294.25 $6,369.30 $7,747.26 $9,296.71 $10,691.22 $12,294.90 $14,139.14 $15,835.83 $17,419.42 $19,161.36 $21,077.49 $23,185.24

$0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00

Cost of sales $1,112.79 $1,350.01 $1,681.43 $2,191.44 $2,605.21 $3,148.69 $3,778.43 $4,345.19 $4,996.97 $5,746.51 $6,436.10 $7,079.71 $7,787.68 $8,566.44 $9,423.09

Store operating expenses $867.96 $1,109.78 $1,379.57 $1,790.17 $2,165.91 $2,660.64 $3,192.77 $3,671.69 $4,222.44 $4,855.81 $5,438.50 $5,982.35 $6,580.59 $7,238.65 $7,962.51

Other operating expenses $72.41 $106.08 $141.35 $171.65 $197.02 $261.75 $314.10 $361.22 $415.40 $477.71 $535.04 $588.54 $647.39 $712.13 $783.35

D&A expense $163.50 $205.56 $244.67 $289.18 $340.17 $382.87 $459.45 $528.37 $607.62 $698.76 $782.62 $860.88 $946.97 $1,041.66 $1,145.83

G and A Expenses $179.85 $234.58 $244.55 $304.29 $357.11 $473.45 $568.14 $653.36 $751.37 $864.07 $967.76 $1,064.54 $1,170.99 $1,288.09 $1,416.90

Subtotal operating Expenses $0.00 $0.00 $3,691.58 $4,746.73 $5,665.43 $6,927.41 $8,312.89 $9,559.83 $10,993.80 $12,642.87 $14,160.01 $15,576.02 $17,133.62 $18,846.98 $20,731.68

Income from equity investees $27.74 $33.45 $36.90 $59.07 $76.75 $91.04 $109.24 $125.63 $144.48 $166.15 $186.08 $204.69 $225.16 $247.68 $272.45

Operating income $280.22 $316.34 $420.85 $606.59 $780.62 $910.89 $1,093.06 $1,257.02 $1,445.58 $1,662.41 $1,861.90 $2,048.09 $2,252.90 $2,478.19 $2,726.01

Interest and other income, Net $10.77 $9.30 $11.62 $14.14 $15.83 $13.47 $16.16 $18.58 $21.37 $24.58 $27.53 $30.28 $33.31 $36.64 $40.30

EBIT $288.05 $339.00 $432.47 $620.73 $796.44 $924.35 $1,109.22 $1,275.61 $1,466.95 $1,686.99 $1,889.43 $2,078.37 $2,286.21 $2,514.83 $2,766.32

Income taxes $107.71 $126.31 $167.12 $231.75 $301.98 $331.89 $398.26 $458.00 $526.70 $605.71 $678.39 $746.23 $820.86 $902.94 $993.24

Net earnings $ $180.34 $212.69 $265.36 $388.97 $494.47 $592.47 $710.96 $817.61 $940.25 $1,081.28 $1,211.04 $1,332.14 $1,465.36 $1,611.89 $1,773.08

40

1.3 Cash Flows Operating Leases

STARBUCKS CORP: Cash Flow

OPERATING ACTIVITIES 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Net earnings $ $621,160,000 $710,961,600 $817,605,840 $940,246,716 $1,081,283,723 $1,211,037,770 $1,332,141,547 $1,465,355,702 $1,611,891,272 $1,773,080,399

Net cash provided by Operating Activity $1,545,091,000 $1,109,224,800 $1,275,608,520 $1,466,949,798 $1,686,992,268 $1,889,431,340 $2,078,374,474 $2,286,211,921 $2,514,833,113 $2,766,316,425

Net cash used by investing Activities ($970,999,000) N/A N/A N/A N/A N/A N/A N/A N/A N/A Net cash provided/(used) by Fin activities ($458,531,000) N/A N/A N/A N/A N/A N/A N/A N/A N/A

Effect of exchange rate changes $3,995,000 N/A N/A N/A N/A N/A N/A N/A N/A N/A

Net increase in cash and cash equiv $119,556,000 ($16,682,309) $35,212,904 $40,494,839 $46,569,065 $53,554,425 $61,587,589 $70,825,727 $81,449,586 $93,667,024

OPERATING ACTIVITIES 2001 2002 2003 2004 2005

Net earnings $ $180,335,000 $212,686,000 $265,355,000 $388,973,000 $494,467,000

Net cash provided by Operating Activity $456,305,000 $477,685,000 $616,118,000 $858,537,000 $923,608,000

Net cash used by investing Activities ($428,532,000) ($485,340,000) ($616,424,000) ($749,512,000) ($221,308,000) Net cash provided/(used) by Fin activities $9,166,000 $54,522,000 $30,763,000 ($66,545,000) ($673,827,000)

Effect of exchange rate changes ($174,000) $1,560,000 $3,278,000 $3,111,000 $283,000

Net increase in cash and cash equiv $36,765,000 $48,427,000 $33,735,000 $45,591,000 $28,756,000

41

STARBUCKS CORP: Balance Sheet (in millions of dollars)

ASSETS 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Current assets: Cash and cash equivalents $ $113.24 $99.68 $113.24 $99.68 $200.91 $145.05 $173.81 $251.44 $128.05 $147.25 $169.34 $194.74 $223.95 $257.55 $296.18

Short-term investments - available-for-sale $101.40 $217.30 $101.40 $217.30 $128.91 $483.16 $95.38 $240.25 $170.73 $196.34 $225.79 $259.66 $298.61 $343.40 $394.91

Short-term investments - trading securities $5.91 $10.36 $5.91 $10.36 $20.20 $24.80 $37.85 $46.85 $21.34 $24.54 $28.22 $32.46 $37.33 $42.92 $49.36

Accounts receivable $90.43 $97.57 $90.43 $97.57 $114.45 $140.23 $190.76 $197.77 $110.97 $127.62 $146.76 $168.78 $194.09 $223.21 $256.69

Inventories $221.25

$263.17 $221.25 $263.17 $342.94 $422.66 $546.30 $452.65 $1,048.62 $1,174.45 $1,315.39 $1,446.93 $1,591.62 $1,750.78 $1,925.86

Prepaid expenses and other current assets $29.83 $42.35 $29.83 $42.35 $55.17 $71.35 no trend


Total current assets $593.93 $772.64 $593.93 $772.64 $924.03 $1,350.90 $1,209.33 $1,351.93 $853.65 $981.69 $1,128.95 $1,298.29 $1,493.03 $1,716.99 $1,974.54

Long-term investments -available-for-sale $0.00 $0.00 $0.00 $0.00 $136.16 $135.18 no trend

Equity and other investments $63.10 $102.54 $63.10 $102.54 $144.26 $167.74 $201.46 $207.47 $128.05 $147.25 $169.34 $194.74 $223.95 $257.55 $296.18

Property, plant and equipment, net $2,450.88 $2,873.29 $271.91 $341.55 $364.76 $372.38 $1,842.02 $1,870.79 $2,987.76 $3,435.93 $3,951.31 $4,544.01 $5,225.61 $6,009.46 $6,910.87

Other assets $31.87 $43.69 $31.87 $43.69 $52.11 $85.56 no trend

Other intangible assets $0.00 $9.86 $0.00 $9.86 $24.94 $26.80 $35.41 $35.94 $23.48 $27.00 $31.05 $35.70 $41.06 $47.22 $54.30

Goodwill $21.85 $19.90 $21.85 $19.90 $63.34 $68.95 $92.47 $92.34 $46.95 $53.99 $62.09 $71.41 $82.12 $94.43 $108.60

TOTAL ASSETS $ $3,099.63 $3,821.93 $3,099.63 $1,290.19 $1,709.60 $2,207.51 $3,514.07 $3,711.51 $4,268.23 $4,908.47 $5,644.74 $6,491.45 $7,465.16 $8,584.94 $9,872.68

LIABILITIES & SHAREHOLDERS EQUITY

Current liabilities: Accounts payable $127.91 $135.99 $127.91 $135.99 $168.98 $199.35 $220.98 $208.59 $153.66 $176.70 $203.21 $233.69 $268.75 $309.06 $355.42

Accrued compensation and related costs $81.46 $105.90 $81.46 $105.90 $152.61 $208.93 $232.35 $229.06 $136.58 $157.07 $180.63 $207.73 $238.89 $274.72 $315.93

Accrued occupancy costs $35.84 $51.20 $35.84 $51.20 $56.18 $29.23 no trend

Accrued taxes $70.35 $54.24 $70.35 $54.24 $54.93 $62.96 no trend

Short-term borrowings $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 no trend

Other accrued expenses $40.12 $72.29 $40.12 $72.29 $101.80 $123.68 $198.08 $187.38 $96.04 $110.44 $127.01 $146.06 $167.97 $193.16 $222.14

Deferred revenue $26.92 $42.26 $26.92 $42.26 $73.48 $121.38 $175.05 $309.29 $74.69 $85.90 $98.78 $113.60 $130.64 $150.24 $172.77

Current portion of long-term debt $0.70 $0.71 $0.70 $0.71 $0.72 $0.74 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75 $0.75

Total current liabilities $383.28 $462.60 $383.28 $462.60 $608.70 $746.26 $1,227.00 $1,270.71 $1,073.50 $1,213.05 $1,370.75 $1,548.94 $1,750.31 $1,977.85 $2,234.97


Long-term debt $1,320.88 $1,612.61 -$858.09 -$919.13 -

$1,015.79 -

$1,175.42 no trend

Other long-term liabilities $0.41 $1.04 $0.41 $1.04 $1.05 $144.68 no trend

Shareholders equity: Common stock $791.62 $891.04 $791.62 $891.04 $959.10 $956.69 $90.97 $61.43 $61.43 $61.43 $61.43 $61.43 $61.43 $61.43 $61.43

Other additional paid-in-capital $0.00 $39.39 $0.00 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39 $39.39

Retained earnings $589.71 $801.34 $589.71 $980.37 $1,506.01 $2,168.29 $2,886.98 $3,749.41 $4,741.21 $5,881.77 $7,159.20 $8,589.92 $10,163.72 $11,894.89 $13,799.18

Accumulated other comprehensive income -$5.41 -$8.58 -$5.41 -$8.58 $14.25 $29.24 no trend

Total shareholders equity $1,375.93 $1,723.19 $1,375.93 $1,902.22 $2,518.75 $3,193.61 $3,038.26 $3,868.65 $4,842.03 $5,982.59 $7,260.02 $8,690.75 $10,264.54 $11,995.72 $13,900.01

TOTAL LIABILITIES & SHAREHOLDERS $ $3,099.63 $3,821.93 $920.66 $1,469.22 $2,145.93 $2,930.90 $4,461.69 $5,347.37 $4,268.23 $4,908.47 $5,644.74 $6,491.45 $7,465.16 $8,584.94 $9,872.68

1.4 Balance Sheet Capitalized Leases

42

1.5 Income Statement Capitalized Leases



2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Net revenues:


Specialty:

Licensing $0.00 $0.00 $409.55 $565.80 $673.02 $854.04 $1,024.85 $1,178.57 $1,355.36 $1,518.00 $1,700.16 $1,870.18 $2,057.20 $2,262.91 $2,489.21


Total specialty $419.39 $496.00 $625.90 $836.87 $977.37 $1,197.48 $1,436.97 $1,652.52 $1,900.40 $2,128.45 $2,383.86 $2,622.25 $2,884.47 $3,172.92 $3,490.21


$0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00

Cost of sales $946.24 $1,149.18 $1,443.69 $1,908.09 $2,264.74 $2,808.22 $3,369.86 $3,875.34 $4,456.64 $4,991.43 $5,590.41 $6,149.45 $6,764.39 $7,440.83 $8,184.91



D&A expense $232.72 $290.16 $328.82 $400.89 $473.19 $567.83 $681.39 $783.60 $901.14 $1,009.28 $1,130.39 $1,243.43 $1,367.78 $1,504.56 $1,655.01

G and A Expenses $179.85 $234.58 $244.55 $304.29 $357.11 $473.45 $568.14 $653.36 $751.37 $841.53 $942.52 $1,036.77 $1,140.44 $1,254.49 $1,379.94



Operating income $377.55 $432.56 $574.45 $778.23 $988.07 $1,066.41 $1,279.69 $1,471.64 $1,692.39 $1,895.47 $2,122.93 $2,335.22 $2,568.75 $2,825.62 $3,108.18


EBIT $362.63 $418.18 $557.78 $757.39 $964.26 $1,050.58 $1,260.69 $1,449.80 $1,667.27 $1,867.34 $2,091.42 $2,300.56 $2,530.62 $2,783.68 $3,062.05

Income taxes $107.71 $126.31 $167.12 $231.75 $301.98 $331.89 $398.26 $458.00 $526.70 $589.91 $660.70 $726.77 $799.44 $879.39 $967.33

Net earnings $ $254.91 $291.87 $390.66 $525.64 $662.28 $718.69 $862.43 $991.79 $1,140.56 $1,277.43 $1,430.72 $1,573.80 $1,731.17 $1,904.29 $2,094.72

43

1.6 Cash Flows of Operating Leases



2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Net revenues:


Specialty:

Licensing $0.00 $0.00 $409.55 $565.80 $673.02 $854.04 $1,024.85 $1,178.57 $1,355.36 $1,518.00 $1,700.16 $1,870.18 $2,057.20 $2,262.91 $2,489.21


Total specialty $419.39 $496.00 $625.90 $836.87 $977.37 $1,197.48 $1,436.97 $1,652.52 $1,900.40 $2,128.45 $2,383.86 $2,622.25 $2,884.47 $3,172.92 $3,490.21


$0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00

Cost of sales $946.24 $1,149.18 $1,443.69 $1,908.09 $2,264.74 $2,808.22 $3,369.86 $3,875.34 $4,456.64 $4,991.43 $5,590.41 $6,149.45 $6,764.39 $7,440.83 $8,184.91



D&A expense $232.72 $290.16 $328.82 $400.89 $473.19 $567.83 $681.39 $783.60 $901.14 $1,009.28 $1,130.39 $1,243.43 $1,367.78 $1,504.56 $1,655.01

G and A Expenses $179.85 $234.58 $244.55 $304.29 $357.11 $473.45 $568.14 $653.36 $751.37 $841.53 $942.52 $1,036.77 $1,140.44 $1,254.49 $1,379.94



Operating income $377.55 $432.56 $574.45 $778.23 $988.07 $1,066.41 $1,279.69 $1,471.64 $1,692.39 $1,895.47 $2,122.93 $2,335.22 $2,568.75 $2,825.62 $3,108.18


EBIT $362.63 $418.18 $557.78 $757.39 $964.26 $1,050.58 $1,260.69 $1,449.80 $1,667.27 $1,867.34 $2,091.42 $2,300.56 $2,530.62 $2,783.68 $3,062.05

Income taxes $107.71 $126.31 $167.12 $231.75 $301.98 $331.89 $398.26 $458.00 $526.70 $589.91 $660.70 $726.77 $799.44 $879.39 $967.33

Net earnings $ $254.91 $291.87 $390.66 $525.64 $662.28 $718.69 $862.43 $991.79 $1,140.56 $1,277.43 $1,430.72 $1,573.80 $1,731.17 $1,904.29 $2,094.72

44

1.7 AEG Valuation

1 2 3 4 5 6 7 8 Perp

Forecast Years

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

EPS $0.91 $1.09 $1.26 $1.44 $1.62 $1.81 $1.99 $2.19 $2.41 $2.65

Cum-Dividend Earnings $1.09 $1.26 $1.44 $1.62 $1.81 $1.99 $2.19 $2.41 $2.65

Normal Earnings $1.06 $1.27 $1.46 $1.68 $1.88 $2.11 $2.32 $2.55 $2.80

Abnormal Earning Growth (AEG) $0.03 ($0.01) ($0.02) ($0.06) ($0.07) ($0.11) ($0.13) ($0.14) ($0.15)

PV Factor 0.860 0.739 0.636 0.547 0.470 0.404 0.347 0.299

PV of AEG $0.03 ($0.01) ($0.01) ($0.03) ($0.03) ($0.05) ($0.04) ($0.04)

Core EPS $0.91

Total PV of AEG ($0.19)

Continuing (Terminal) Value ($0.94)

PV of Terminal Value ($0.28)

Total PV of AEG ($0.47)

Total Average EPS Perp (t+1) $0.44

Capitalization Rate (perpetuity) 0.163

Value Per Share $2.69

Ke 0.163 Sensitivity Analysis

g 0 g

0 0.05 0.08 0.1

Ke 0.133 $4.99 $3.97 $2.44 ($0.13)

Actual Price per share $38.26 0.143 $4.02 $3.07 $1.78 ($0.09)

0.153 $3.28 $2.42 $1.34 ($0.06)

0.163 $2.69 $1.93 $1.03 ($0.04)

0.173 $2.23 $1.56 $0.81 ($0.03)

Overvalued (< 90%) 34.434

Undervalued (> 110%) 42.086

45

1.8 Residual Income Valuation

Residual Income Valuation WACC(AT) 0.0804 Kd 0.0347 Ke 0.163

0

0 1 2 3 4 5 6 7 8 9 10

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

EPS (Earnings Per Share) $0.91 $1.09 $1.26 $1.44 $1.62 $1.81 $1.99 $2.19 $2.41 $2.65

BPS (Book Value Equity per Share) 2.789957033 $3.70 $4.79 $6.05 $7.49 $9.11 $10.92 $12.91 $15.10 $17.51 $20.16

$3.70

Perpetuity

EPS (Earnings Per Share) $0.91 $1.09 $1.26 $1.44 $1.62 $1.81 $1.99 $2.19 $2.41 $2.65

Normal Earnings (Notice "Lag") 0.45 0.60 0.78 0.99 1.22 1.48 1.78 2.10 2.46 2.85

Residual Income 0.64 0.65 0.66 0.63 0.59 0.51 0.41 0.31 0.19 -0.20

PV Factor 0.8598 0.7393 0.6357 0.5466 0.4700 0.4041 0.3475 0.2988 0.2569 0.2209

PV of Residual Income 0.548 0.482 0.421 0.345 0.277 0.205 0.143 0.091 0.049 -0.045

Total PV of Annual Residual Income 2.562

Continuing (Terminal) Value Perpetuity -

0.337184143

PV of Terminal Value Perpetuity -0.087

BPS (Book Value Equity per Share) 2.65 Ke

Estimated Price per Share (end of 2005) 5.13 g 0.103 0.113 0.123 0.133 0.143 0.153 0.163

0 $9.46 $8.35 $7.46 $6.73 $6.12 $5.60 $5.14

Logical Test for Growth in Perpetuity g 0.03 0.01 $9.60 $8.43 $7.50 $6.75 $6.13 $5.59 $5.14

0.02 $9.77 $8.52 $7.55 $6.77 $6.13 $5.59 $5.13

Observed Share Price (end of 2005) 38.26 0.03 $9.99 $8.64 $7.61 $6.80 $6.14 $5.59 $5.13

0.04 $10.27 $8.78 $7.68 $6.83 $6.15 $5.59 $5.12

Initial Ke 0.163 0.05 $10.67 $8.97 $7.77 $6.87 $6.16 $5.59 $5.11

Overvalued (< 90%) 34.434

Undervalued (> 110%) 42.086

46

1.9 Present Value of Cash Flows WACC(AT) 0.0804 Kd 0.0347

In Millions 0 1 2 3 4 5 6 7 8 9 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 EPS (Earnings Per Share) $0.91 $1.09 $1.26 $1.44 $1.62 $1.81 $1.99 $2.19 $2.41 2BPS (Book Value Equity per Share) $2.79 $3.59 $4.47 $5.57 $6.82 $8.27 $9.88 $11.69 $13.69 $15.88 18.2Cash Flow to Firms Assets (Free Cash Flow) 1,051 1,261 1,450 1,667 1,867 2,091 2,301 2,531 2,784 PV Factor 0.9256 0.8567 0.7930 0.7339 0.6793 0.6288 0.5820 0.5387 0.4986 PV of Free Cash Flows 972.40 1080.04 1149.62 1223.68 1268.53 1315.02 1338.88 1363.17 1387.90 Total PV of Annual Free Cash Flows 11,099.23 Continuing (Terminal) Value Perpetuity WACC 38085.15995 PV of Terminal Value Perpetuity 18988.6725 0.0304 0.0404 0.0504 0.0604 0.0704 0.0804 0.0904 Value of Firm 30,087.91 g 0 110.54 79.39 60.74 48.37 39.60 33.08 28.06 Book Value of Liabilities $3,951 0.01 158.27 101.49 72.97 55.89 44.55 36.50 30.51 Estimated Market Value of Equity 26,137.07 0.02 297.80 145.25 93.24 67.11 51.45 41.04 33.65 Number of Shares 790 0.03 N/A 273.16 133.39 85.73 61.77 47.39 37.84 Estimated Price per Share (end of 2005) $33.08 0.04 N/A N/A 250.76 122.60 78.88 56.88 43.68 Observed Share Price $38.26 33.08 Overvalued (< 90%) $34.43 37.75 Undervalued (> 110%) $42.09

47

1.10 LR ROE Valuation

1 2 3 4 5 6 7 8 9 10 perp

Forecast Years

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Beginning BE (per share) 2.79 3.70 4.79 6.05 7.49 9.11 10.92 12.91 15.10 17.51 Earnings Per Share 0.91 1.09 1.26 1.44 1.62 1.81 1.99 2.19 2.41 2.65 Ending BE (per share) 2.79 3.70 4.79 6.05 7.49 9.11 10.92 12.91 15.10 17.51 27.31 Ke 0.163 ROE 32.61% 29.51% 26.20% 23.88% 21.59% 19.88% 18.25% 16.97% 15.96% Growth inBVE 32.61% 29.51% 26.20% 23.88% 21.59% 19.88% 18.25% 16.97% 15.96% Actual Price per share $37.75 Average ROE 22.76% 2.79 Average Growth in BVE 22.76% LRResInc Perp Value 0.00 Estimated Value (2005) 38.26

48

1.11 Costs of Equity

Regression Statistics

Multiple R 0.4524588 R Square 0.204719 Adjusted R Square 0.1685698 Standard Error 0.0717287

Observations 24

ANOVA

df SS MS F Significance F

Regression 1 0.029137068 0.0291371 5.6631765 0.026420362 Residual 22 0.113190096 0.005145

Total 23 0.142327163

Coefficients Standard

Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%

Intercept 0.0099543 0.015016803 0.6628802 0.5142931 -0.021188602 0.0410973 -0.0211886 0.04109729

X Variable 1 1.6684846 0.701119667 2.379743 0.0264204 0.214451397 3.1225178 0.2144514 3.12251777

Months Beta R^2 Ke 10 Year 60 0.5230 0.05779 0.083 48 0.3608 0.01808 0.071 36 1.1748 0.11543 0.128 24 1.6685 0.20472 0.1635 Year 60 0.5245 0.05827 0.084 48 0.3643 0.01851 0.072 36 1.1820 0.11698 0.130 24 1.6645 0.20443 0.1632 Year 60 0.5272 0.05881 0.085 48 0.3677 0.01891 0.074 36 1.1895 0.11850 0.131 24 1.6604 0.20342 0.1646 Month 60 0.5295 0.05914 0.086 48 0.3686 0.01900 0.075 36 1.1933 0.11904 0.133 24 1.6587 0.20242 0.164

49

1.12 Costs of Debt 1.13 WACC

Capitalized Leases WACC $2,090,634,000 Total Equity $6,041,470,976 Total Assets 0.163 Ke WACC 0.346047181 Ve/Vf 0.653953 Vl/Vf 0.059 kd

0.05640569 0.6211-tax rate

0.034714 0.022701 WACC 8.04%

Capitalized Leases Kd Interest Rate Weight Accounts payable $ 0.053 0.0636 0.0034 $220,975,000 Accrued taxes 0.0473 0.0225 0.0011 $78,293,000 Short-term borrowings 0.04 0.0797 0.0032 $277,000,000 Deferred revenue 0.0473 0.0504 0.0024 $175,048,000 Long-term debt 0.06 0.7281 0.0437 $2,530,275,976 Other long-term liabilities 0.06 0.0557 0.0033 $193,565,000 1.00 5.70% $3,475,156,976

Kd=5.59% After Tax=3.47%

50

1.14 Z-Scores


2001 0.07 0.1902529 0.116990047 3.77 0.71931 2002 0.08 0.2096682 0.109416293 4.41 0.730758 2003 0.07 0.1902529 0.179949407 (27.28) 1.112916 2004 0.24 0.759867 0.587038883 (46.83) 3.454826 2005 0.18 0.8809116 0.564024134 (60.23) 3.153906


2001 3.72 0.081551 0.266354 0.386067156 2.264524 0.71931

2002 4.13 0.097348 0.2935355 0.361073767 2.644421 0.730758

2003 -

14.31 0.081551 0.266354 0.593833045 -16.3668 1.112916

2004 -

21.36 0.288374 1.0638138 1.937228313 -28.1009 3.454826

2005 -

29.67 0.221333 1.2332763 1.861279641 -36.1366 3.153906 price shares 1 8.56 760000000 $6,505,600,000 2 11.92 776000000 $9,249,920,000 3 15.8 786000000 $12,418,800,000 4 26.44 767000000 $20,279,480,000 5 28.28 794000000 $22,454,320,000

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