The COVID-19 pandemic is the ultimate litmus test for business quality and durability.

If a business survives this crisis, they’re basically unkillable.

When things get crazy, people like to turn to what’s consistent and comfortable.

That benefits businesses with visible and trustworthy brand names.

With a wave of bankruptcies sure to take out poorly-positioned businesses, these brand names will only become more valuable.

I’ve relied on quality brands both as a consumer and investor.

And I have to say, it’s been even better on the investor side.

Investing in quality brands helped me to go from below broke at age 27 to financially free at 33, as I describe in my Early Retirement Blueprint.

I now control the FIRE Fund, a six-figure collection of some of the best brands in the world.

This real-money portfolio, by the way, generates enough five-figure passive dividend income for me to live off of – while I’m still in my 30s.

I’ve invested in brands using the broader investment strategy of dividend growth investing.

This strategy advocates buying and holding shares in quality businesses that pay shareholders reliable and rising cash dividends.

The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Reliable and rising cash dividends shows that management is prudent with capital and producing the profit they claim.

Can’t fake cash. 

You also can’t fake a great brand. People will buy it, or they won’t.

But dividend growth investing is more than just picking out great brands and rising dividends.

Fundamental analysis and valuation are both critical.

The latter aspect in particular can dramatically affect the outcome of an investment.

Price is only what you pay. It’s value that you get.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk. 

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value. It’s protection against the possible downside.

Buying stocks with great brands and rising dividends at attractive valuations will likely lead to a significant amount of wealth and passive income over the course of one’s lifetime.

The good news is, finding and valuing these stocks isn’t a difficult exercise.

Valuation has become easier than ever, thanks in part to fellow contributor Dave Van Knapp’s Lesson 11: Valuation.

One of many “lessons” he’s penned on dividend growth investing, Lesson 11 explicitly lays out a valuation template that you can apply to just about any dividend growth stock out there.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Starbucks Corporation (SBUX)

Starbucks Corporation (SBUX) is the world’s leading retailer of high-quality, specialty coffee products. These products are sold in 31,000 stores across 80 different markets, in addition to multi-channel retail.

Company-owned stores accounted for approximately 81% of FY 2019 revenue, while licensed stores accounted for approximately 11% of FY 2019 revenue. The remainder was made up of Other sales.

The company splits its revenue across two primary geographical segments: Americas, ~69% of FY 2019 revenue; and International, ~23%. Channel Development (retail CPG) and Corporate and Other accounted for the remainder of revenue.

When we talk about quality brands that are visible and trustworthy, there are few that come to mind faster than Starbucks.

Millions of people flock to Starbucks every day because of their consistency and quality.

They know exactly what they’re gonna get when they buy a product. And they also know their products are going to come with a standard of service.

A Starbucks drink is an attainable luxury for everyone.

That’s what the brand tells you.

In addition, Starbucks offers luxurious lounges in which to enjoy their products and services.

Combining the coffee with the in-store experience means Starbucks is one of the rare companies that offers both a product and an experience that people around the world enjoy.

In a world in which a lot of consumers have to choose between spending their money on stuff or experiences, Starbucks offers both.

Because of the pandemic, lounge access is limited.

This does reduce the company’s experiential value proposition.

That’s not going to hurt Starbucks over the long run, though.

Their relentless focus on customer service put them way ahead of the curve.

They have traditional in-store purchases, drive-through options, mobile ordering, and delivery.

The company’s mastery of technology has allowed them to get their products in customers’ hands, while still offering the service they’re known for.

In addition, they put together a $7.15 billion licensing deal that saw Nestle SA (NSRGY) pay Starbucks for the right to exclusively sell the chain’s packaged coffees and teas around the world.

Starbucks now has Nestle’s global distribution might working for them, and it means that consumers everywhere are able to bypass stores altogether and still get their coffee fix.

Keep in mind, too, that the lounge closures are temporary.

Yet you’d think this is permanent by looking at the drop in the stock.

That’s simply not true.

However, the stock market’s emotional overreaction to these temporary issues has presented a great long-term opportunity on one of the highest-quality brands you could possibly find.

That quality carries over to the dividend, too.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Starbucks has increased its dividend for 10 consecutive years, with a five-year dividend growth rate of 22.1%.

That blistering growth comes on top of the stock’s market-beating yield of 2.11%.

This yield, by the way, is more than 50 basis points higher than the stock’s five-year average yield.

And while the payout ratio, at 146%, looks extremely unsustainable, it’s only so high because of the pandemic’s temporary effects on the company’s GAAP earnings.

When things normalize, which will probably start to happen toward the end of this year, Starbucks will almost certainly go back to printing money again.

For perspective, their payout ratio has historically been less than 50%.

Their most recent dividend declaration came in at the end of June, showing no cut to the dividend.

Starbucks is clearly committed to the dividend. That sends a great message to shareholders.

Revenue and Earnings Growth

Now, this is looking at what’s already occurred.

But investors are putting today’s capital at risk for tomorrow’s rewards.

It’s the future that investors care most about.

I’ll now build out a forward-looking growth trajectory for Starbucks, which will later help us estimate the stock’s intrinsic value.

This trajectory will be partially based on what Starbucks has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near term professional prognostication for profit growth.

Combining the proven past with a future forecast in this manner should tell us a lot about where Starbucks might be going.

The company increased its revenue from $10.707 billion in FY 2010 to $26.508 billion in FY 2019.

That’s a compound annual growth rate of 10.60%.

I usually like to see mid-single-digit top-line growth from a mature business.

Starbucks blew that out of the water.

Meantime, earnings per share expanded from $0.62 to $2.92 over this same period, which is a CAGR of 18.79%.

Just super impressive stuff here.

Helping to propel some of that excess bottom-line growth was share buybacks.

Starbucks reduced its outstanding share count by almost 20% over the last decade.

There was also an expansion of net margin.

And the comps are remarkable.

Global comparable store sales were up an amazing 5% for FY 2019. And that’s in a year in which they opened almost 2,000 new stores.

2020 will no doubt be tough for comps, margins, and just about every other metric.

However, long-term investors should be thinking in terms of decades, not individual years.

Looking forward, CFRA is projecting that Starbucks will compound its EPS at an annual rate of 14% over the next three years.

I give CFRA full credit for putting up a number and going out on a limb, as it’s so difficult right now to forecast anything.

I think it’s fair to say that 2020 will be ugly.

But that might end up creating a bit of a “coiled spring” for Starbucks. It’s pent-up demand.

The company might have customers coming back in droves, when the entire operation is running smoothly once again.

Everyone I’ve personally spoken to is anxious to get back to normal life, which bodes well for Starbucks.

CFRA notes a steep drop in revenue for FY 2020, but they also see a very healthy rebound of 20% YOY revenue growth when looking out at FY 2021.

Again, there’s the very real possibility of a coiled spring here in terms of demand and traffic.

Regardless of what the company ends up actually doing over the next year or two, Starbucks is simply one of the best brands in the world when you’re thinking about the next 10-20 years.

When looking at long-term dividend growth, that easily sets them up for high-single-digit dividend raises.

Financial Position

Moving over to the balance sheet, the company maintains a rock-solid financial position.

There has been some deterioration in the balance sheet in recent years, with Starbucks taking on debt to fuel extra shareholder returns. And the balance sheet looks worse than it really is due to negative equity.

However, with slightly over $11 billion in long-term debt (as of the end of FY 2019) on a $90 billion market cap, Starbucks has no issues whatsoever with debt.

Furthermore, the interest coverage ratio is north of 14.

Profitability is very healthy, as one would expect for a world-class enterprise.

Over the last five years, the company has averaged annual net margin of 14.47%; however, return on equity has become inapplicable because of the aforementioned negative shareholders’ equity.

It’s worth noting that there’s been a tremendous margin expansion story playing out here. Net margin was in the high-single-digit range a decade ago. It’s now routinely in the double digits.

Overall, there’s almost nothing to dislike about Starbucks as a long-term investment.

With incredible brand value, economies of scale, a global distribution network, and a competent omnichannel strategy, Starbucks has durable competitive advantages.

Of course, there are risks to consider.

Regulation, competition, and litigation are omnipresent risks in every industry.

Competition is arguably the biggest risk of those three. The industry is extremely competitive, although Starbucks does maintain enviable advantages over its competitors.

There are volatile input costs at play, primarily in the form of labor and raw materials.

Being a global company, they’re exposed to macroeconomic issues and broad economic slowdowns. The pandemic has painfully highlighted this.

Perhaps the biggest risk to long-term returns is the nature of the company itself. Their massive size means the law of large numbers will end up working against them at some point.

With these risks known, I still think Starbucks is a fantastic long-term investment.

That’s particularly so when the valuation is appealing.

With the stock still down 20% from its 52-week high, the valuation does look appealing now…

Stock Price Valuation

The stock’s P/E ratio of 70.12 isn’t a useful metric.

That’s because sales and GAAP results are so far out of whack with the long-term reality of the business model.

So you have to ask yourself whether or not you think Starbucks will be back to normal within 12-24 months.

If you think the current situation is going to persist for decades to come, then Starbucks doesn’t look cheap at all.

However, I think life will return to normal, more or less, within the next year.

It’s interesting that the P/S ratio, at 3.8, is actually less than the stock’s own five-year average.

And the yield, as noted earlier, is notably higher than its own recent historical average.

So the stock does look cheap based on basic valuation metrics. But how cheap might it be? What would a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 8%.

This DGR is at the top end of what I allow for when I use a DDM analysis.

If there’s any company that deserves the benefit of the doubt, it’s this one.

Starbucks is a true juggernaut. The commitment to the dividend is clear, the brand power is immense, and the dividend coverage under normal circumstances is excellent.

I’d agree that this 8% looks generous over the next year or so. But when looking at the company’s potential over the next few decades, I think this will average out nicely.

The DDM analysis gives me a fair value of $88.56.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

The stock looks at least moderately undervalued from where I’m sitting.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates SBUX as a 4-star stock, with a fair value estimate of $90.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates SBUX as a 4-star “BUY”, with a 12-month target price of $90.00.

I came out slightly low, but we have a pretty tight consensus here. Averaging the three numbers out gives us a final valuation of $89.52, which would indicate the stock is possibly 15% undervalued.

Bottom line: Starbucks Corporation (SBUX) is a global juggernaut with one of the most recognizable and powerful brands in the world. With a market-beating yield, a clear commitment to the dividend, strong long-term dividend growth, and the potential that shares are 15% undervalued, this looks like one of the best combinations of quality and value in the market today.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

Note from DTA: How safe is SBUX’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 67. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, SBUX’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.