Coca-Cola (KO) Offers Good Risk-Adjusted Returns

To no surprise, Coca-cola (KO) showed up on my watchlist this week of companies with excellent long-term returns on equity. KO is widely regarded as one of the finest businesses in the world. Even after well over a hundred years of growth, the company is still expanding and has huge untapped and under-tapped markets ahead if it. Its moat is wide, and it has shown a great ability to not only grow its core brands, but also to adapt to local tastes and develop or acquire new products.

The stock has performed well as of late and is currently very close to its 52-week high.

Today, I am taking a look at KO’s valuation. I am using the general approach put forth in Prem Jain’s excellent book on Warren Buffett called Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management When Investing.

Based on KO’s long-term track record, I am estimating that EPS will grow at a rate of 8% annually over the next decade. The mean EPS estimate for 2010 is $3.50. Assuming 8% annual growth, EPS will be $7.54 in 2020. I am further assuming that given KO’s superior economics it deserves a P/E of 20, if fully valued. Its median P/E over the past decade has been 21. That would give KO a price of $150.80 in 2020. Using a discount rate of 7%, the present value of KO’s stock is $76.67.

Now let’s look at KO’s dividends. I estimate that KO will pay a dividend of $1.84 over the next 12 months and that the dividend will also grow at a rate of 8% over the next decade. By my estimate, KO’s dividend has grown by over 10% annually over the past decade. Using the same discount rate of 7%, the NPV of KO’s dividends over the next decade is $17.94.

Add the NPV of the dividends ($17.94) and the present value of the 2020 stock price ($76.67) and you get an intrinsic value of $94.61, which is a discount of about 35% from where it is currently trading. The discount coupled with KO’s formidable moat gives you a margin of safety.

By comparison, using a discount rate of 12% in the same equations gives an intrinsic value of about $62 per share. KO traded as low as $50 per share within the prior 52 weeks. Director Barry Diller purchased $20 million of the stock at $39.91 in March of 2009. Diller recently raised his stake by purchasing another 120,000 shares at a cost of $7.4 million.

Of course, when doing this type of analysis it makes sense to plug in your own assumptions for the growth rate, discount rate and terminal P/E.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.


9 thoughts on “Coca-Cola (KO) Offers Good Risk-Adjusted Returns

  1. Andrew Schneck

    I completely disagree. Coke is one of the more overvalued companies in the market right now. Take a look at the expected return on your money today:

    $8.2 B op. cash flow (or so) – think of this as “owner earnings”, you should still make adjustments to it (based on large shifts in working capital & ongoing capex), but for all intents & purposes, just take it as is.

    $144 B market cap

    $8.2/$144 = 5.7% initial return

    They pay out roughly 50% in dividends, that leaves you with about a 5% return or so initally considering the tax on those dividends…

    If it grows at 8% per year (as you estimate), you can expect to have roughly a 6% annualized over 3 years, 7% annualized over 6 years, 8% annualized over about 10 years. FAR from undervalued, far far far away from good returns. Who wants 5.7% when you can get much higher from WMT (10.8%), ExxonMobil (11%), or Sanofi-Aventis (16%)? – i’m not invested in any of these, just comparing a few large caps to each other. You’ll notice that Buffett holds Sanofi though.

    Greg, I really enjoy your blog & your posts on investment principles, as well as the information you find on specific investors, but this recommendation… not a fan. Present value is highly sensitive to inputs and should probably not be used.. It is a tool for Wall Street to get the highest possible valuations on companies so that they can take them public & have a good offering… also, P/E ratios are just ignoring economic reality. You can’t just assign an aribtray P/E multiple because it sounds good…

    Sorry to be harsh, I’m usually much nicer. This post got a little under my skin.

  2. Greg Speicher Post author

    Andrew, thanks for the comment. I do not believe your math takes into account the fact that KO reinvests about 30% of its net profit which earns a hefty 30% on average. This high ROE compounds retained earnings at a high rate and it is an under-appreciated component of the rare companies like KO that can earn at this level over the long-term.

    Here’s a spreadsheet of the math where I assume a dividend payout ratio of 50%, 30% retained to equity, and 20% for share repurchases which is based on the past 10 years. EPS grows at just under 11% over the assumed 10-year period (not 8%) and the yield in year 10 is 13.76%. This is a slightly different approach than I took in the blog post. The method used in the blog post assumes a modest multiple expansion where the spreadsheet does not.

    The spreadsheet is intended to show that the yield does not grow at a linear 8% but grows at an increasing rate as a greater and greater percentage of retained earnings are able to earn a pure 30% ROE without the premium required on the initial purchase price.

    Regarding other stocks, I’m not arguing that KO is the cheapest stock available but that on a risk adjusted basis it offers good returns. Few companies are as certain as KO over the next 10-20 years and it provides a hedge against inflation and a declining dollar.

    I too am highly skeptical of DCF (present value analysis) for stocks. In a rare few businesses that have long track records, superior economics and a durable proven moat, they can be used with caution.

    I do not view my assumption of KO’s future P/E as arbitrary. Buffett argued in the 1991 shareholder letter that a business that could grow FCF at 6% was worth a P/E of 25 using a discount rate of 10%. KO is in my judgment worth at least 20x earnings (5% yield) in a world where the 10-year treasury is under 4%. KO’s coupon is growing. KO has a long-term median P/E above 20 for good reason.

  3. N/A

    Tell me Mr. Speicher, do companies pay their dividends out of their earnings or out of some other stream of cash flow?

    The answer of course is the former. Thus, adding a DCF calculation (already a highly suspect model in my humble opinion) for the dividends & earnings results in a double counting of dividends. If a company earns a sum of money and reinvests all of it in its business it is certainly worth a different amount than if that money is paid out to you. However, this does not permit one to double count money simply because it was paid out to you and not reinvested in the business. Your calculation only compounds an error of an already erroneous calculation.

    Regardless of your mistakes, thank you very much for sharing your thoughts. I truly appreciate your writing if for no other reason than it helps to clarify my own thoughts.

    (Please forgive my acerbic tongue if it seems so).

  4. Greg Speicher Post author

    N/A, given its high ROE (30%+), KO can actually grow its earnings at 8% (or more) by only reinvesting 30% of its earnings. If you study its cash flow over the past decade or more you will see that only 30% of earnings were reinvested and earnings grew at a CAGR of over 8% (1999 EPS = $1.30, 2010 consensus EPS = $3.50), 20% were used for share repurchases, and 50% were paid out in dividends. Look at the spreadsheet in my response above, you will see that there is no double counting.

    I agree that a DCF calculation is suspect for most companies. In my view KO is an exception given its durable competitive advantages.

    I appreciate your comment.

  5. vinvestor2010

    Hi Greg have you factored in a very strong movement towards non carbonated drinks globally as carbonated drinks are considered unhealthy???
    This may not be exactly quantifiable but it means KO’s earning from Coke will be impacted.
    KO will have to develop new brands in energy drinks/health drinks, or buy out existing firms like it bought out Glaceau a few years ago.
    The net impact, since KO will not be a one product company it’s ROE will come down to a more Pepish 20-25% probably?
    Would appreciate your views on the above

  6. Greg Speicher Post author

    vinvestor2010, KO has long ago moved beyond being a one trick pony (although the original trick is still pretty darn good). See the annual reports for details. One example, KO is the largest juice company in the world. “Still beverages” – juice, water, etc. – made up 23% of 2009 total sales vs. 11% in 2000, and “still beverages” made up 66% of 2009 incremental sales which is accelerating. The Coke franchise extends well beyond colas.

  7. Andrew Schneck

    Greg- sorry to not be more timely in my response… I had forgotten about this post until now.

    I am not always the biggest fan of excel models, but if there was one company I would look at for it, it would definitely be Coke. I like how you’ve displayed the information & various parts… my only concern is the “long runway” allowing for Coke to continually reinvest its earnings across the globe (30% ROE cannot be counted on forever… I don’t see that as possible). I haven’t looked into this (mainly because I believe there are better situations elsewhere), but I’m guessing they still are okay for expanding even more globally than they already are.

    I’m usually more concerned with initial rates of return on my money & less concerned with growth rates… this tends to put a larger emphasis on what I’m getting today for my investment than me “paying up” for future assumptions that may not become reality. Like Buffett, I don’t believe I can predict the future very easily. Phil Fisher has some great ways to look at businesses going forward, but the analysis is not easy, especially when I don’t have the resources available to visit companies all over the states.

    I’m sorry to have argued so harshly against your Coke recommendation- it makes good sense in many ways (especially for Buffett with his $100+ B portfolio).

    Still not a huge P/E multiple fan (check out my blog for the post on valuation if you’re interested where my various cash flow yields come from)… at least you didn’t get the number from nowhere though haha! Also, glad you agree on the DCF model- I would also only use this for Coke or other similar companies with wide moats.

    I realize you don’t want to make your posts crazy long… I am just used to people recommending stocks without many facts supporting the evidence. I like the intellectual underpinning of what you have to say. I wouldn’t buy myself, but it would be a relatively good addition to a diversified portfolio.


Leave a Reply

Your email address will not be published. Required fields are marked *