The valuation question, which has dogged Starbucks (SBUX) seemingly forever, takes on particular meaning for me now since the stock appeared as one of 16 holdings in the Low-Volatility S&P 500 strategy I maintain on Portfolio123’s Ready-to-Go platform. How, one might wonder, can a supposedly “overpriced” stock be included in what’s supposed to be a reduced-risk portfolio? Isn’t this situation very risky, given the possibility Mr. Market may finally come to his senses and gives $SBUX and others like it a well deserved stomping?

Paying Up For Stability

There’s no question SBUX shares have historically served well as a low-volatility selection and also that they are richly valued.

Table 1

  $SBUX Industry Median Beta (5 Yr) 0.69 1.06       PE Based on Curr Yr EPS 34.54 25.22 PEG Ratio 1.87 1.78 Price to Sales 4.50 1.48 Ent. Val to Sales 4.46 1.85 Price to Book 14.15 2.89

High Valuation = High Risk: Says Who?

It’s so easy to assume we’re reducing risk by avoiding supposedly over-priced stocks and/or by trolling in Wall Street’s bargain basement. Who among those who were in the market in the early 2000s can forget the epoch disaster that befell devil-may-care investors who eagerly chased wildly overhyped overpriced stocks?

Actually, it’s not that simple. Academically speaking, lower risk suggests investors’ expected returns should be lower due to lesser “risk premiums.” One way Mr. Market can implement low return is to deliver a stock that simply performs weakly, regardless of the valuation. Another way, though, is to make investors pay higher prices (i.e. valuations) at the outset.

The latter scenario, investors paying up for stability, is definitely out there. Consider the following, from among S&P 500 stocks (possibly the most widely followed closely analyzed group on the planet, meaning things typically happen to the stocks only after a lot of very smart investors gave it a lot of thought put their opinions into action via big dollar-volume trading). I ranked the stocks from highest to lowest based on volatility (defined here as 5-year Beta ) and then split the group down the middle. Table 2 shows how each group fared in terms of standard valuation metrics.

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Table 2

  Stock Risk (Volatility) $SBUX More Less Beta (5 Yr) 1.37 .078 0.69         PE Based on Curr Yr EPS 14.93 19.03 34.54 PEG Ratio 1.43 1.93 1.87 Price to Sales 1.79 2.36 4.50 Ent. Val to Sales 2.05 2.82 4.46 Price to Book 2.70 3.63 14.15