Shares of PepsiCo (NYSE:PEP) have returned 4.6% over the past 12 months. At $69.43, the stock is trading fairly close to its 52-week high of $73.66 attained in August and offers a dividend yield of 3.1%. Does PepsiCo's current risk/reward profile warrant a buy decision? In this article, I will elaborate on my valuation analysis that may help you in formulating the investment decisions.
From a relative valuation perspective, PepsiCo appears to be fully valued based on the company's financial performance relative to its peers' (see comparable analysis chart below). Sell-side analysts on average expect PepsiCo's revenue, EBITDA, and EPS to rise by 3-year CAGRs of 2.4%, 2.0%, and 5.4% respectively over the current and next 2 fiscal years. The consensus estimates considerably underperform the averages of 6.2%, 8.3%, and 8.8% respectively for a peer group consisting of PepsiCo's primary competitors. Similarly, the firm's EBITDA margin is forecasted to shrink by 0.2% over the same period, compared to an average estimated expansion of 1.4% for the comparable companies. On the profit side, PepsiCo's performance remains below the peer average as most of the company's margin and capital return metrics are largely below the par. PepsiCo carries a relatively higher level of debt as reflected by its above-average debt-to-capitalization and debt-to-EBITDA ratios. In terms of liquidity, the company's trailing free cash flow margin is below the average. Due to the higher leverage but lower profitability, PepsiCo's interest coverage ratio is significantly under the par. Both the firm's current and quick ratios are comparable to the group averages, reflecting a healthy corporate balance sheet.
To summarize the financial comparisons, PepsiCo's relatively weaker performance in growth potential, profitability, as well as cash flow generation should suggest a discounted stock valuation relative to the peer-average level. The current valuations at 10.2x forward EV/EBITDA (next 12 months) and 16.2x forward P/E are somewhat reflective of the company's financial condition (see comparable analysis chart above). However, the stock's PEG ratio of 2.8x is markedly above the peer average at 1.9x, indicating that the current valuation may be slightly stretched.
A similar conclusion can be drawn from a historical valuation standpoint. The stock's trailing EV/EBITDA and P/E multiples of 10.3x and 18.5x are currently trading fairly close to their 5-year averages at 10.4x and 17.4x respectively (see chart below), despite the fact that 1) PepsiCo's capital return metrics including ROA, ROIC, and ROE have gradually decreased over the past 5 years; 2) the company has become less profitable as its profitability margins have dropped over the same period; 3) PepsiCo has become more leveraged as shown by the higher debt-to-capitalization ratio and the lower interest coverage rate (see charts below) over time.
I also performed a DCF analysis to further support my view (see DCF chart below). The model incorporates the market's consensus revenue and EBITDA estimates from fiscal 2012 to fiscal 2016. Other free cash flow related items such as depreciation, tax expense, capital expenditure, and net working capital investment are projected based on their historical figure relative to the revenue as the ratio trend appears to be stable over time. To be conservative, a company-specific risk premium of 4.5% is applied in the cost of equity calculation to account for the financial projection risk and a normalized 10-year risk-free rate is used.
As such, based on a terminal growth rate of 1.5% and a WACC of 8.0%, the conservative but reasonable DCF model yields a stock value of $69.11, which is fairly in line with the current share price and suggests a fully valued stock price.
Despite the somewhat rich valuation, according to Thomson One, sell-side analysts are generally bullish on the stock as reflected by the 11 buy ratings out of 17 in total. HSBC's research analyst, Lauren Torres, wrote in the recent research note (sourced from Thomson One, Equity Research):
"Over the course of this year, PepsiCo has invested aggressively behind brand building, accelerated innovation, focused on execution and delivered its productivity initiatives. In light of higher commodity costs, currency headwinds, and restructuring costs, we believe the company is making the right moves for the long-term, which include reducing its cost base, increasing brand equity and strengthening its position in international markets."
In addition, the stock's 3.1% dividend yield would likely be a solid price support given its limited upside due to the strong demand for high-yield assets in the current low-interest market environment. Since 2009, PepsiCo has raised the dividend for 3 times by 6.7%, 7.3%, and 4.5% subsequently. Given the firm's healthy free cash flow margin, I expect the current pace of the dividend growth can be sustained. As such, assuming a target dividend yield range between 3.0% and 3.5%, and supposing that the annualized dividend per share would be raised by 5.0% from the current $2.15 level to $2.26 in the May 2013 payment period. This scenario would suggest a stock value range between $64.56 and $71.73, or a price return range from -7.0% to 3.3% without considering the 3.1% dividend income.
Bottom line, given that PepsiCo's valuation is somewhat rich now but its price downside is likely protected by the continued healthy business execution and dividend growth, I would recommend establishing a long position in the stock by selling out-of-money put options to earn premiums or acquire the stock at a lower valuation level.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data is sourced from Capital IQ unless specified.