In this article I'm going to present some key facts about the stability of the Coca-Cola Company stock and present a valuation for the stock that uses Warren Buffett's preferred earnings measure (the owner's earnings).
The Coca-Cola company (KO) has been around since 1892, its sales, earnings, and world dominance have grown exponentially since them. The company went public in 1919 and one share of stock invested in the day of the IPO at $40 would be worth $9.8 million today (reinvesting dividends), this is a 10.7% real return a year. But one wouldn't need to be lucky enough to invest early on to participate in this wealth generating machine, over the last 30 years its returns with dividends reinvested were around 15% per year (very close to the 10.7% real return since the IPO).
The secret to its success is its brand and the large moat around it. When presented with a choice for a soft drink people will choose Coke over another brand the vast majority of the time even if the other one does better in blindfold study tests, people like to use others as guides for their decisions. The company also protected the integrity of its brand since its foundation. The only way this compounding machine could be stopped would be if they tarnished their brand and alienated their customers; it's safe to say that any CEO would be forced out pretty quickly if such event would occur.
It's a very likely outcome that Coke consumption will continue to grow steadily worldwide just like it did over the last few decades, especially as income per capita increases in developing economies. As a result it's a pretty safe bet that sales, dividends and EPS will be predictable over the next few decades. This point I can't stress enough, this company is as predictable as long-term economic growth for capitalistic economies. As a result it's much safer than a regular stock because its moat makes it more resistant than usual to black swans, bad economic times and disasters. Take a look at EPS over the last decades:
The only period of turmoil was in the end of the 90s when they had a recall of drinks in Europe but its brand value is so strong that they quickly regained the confidence of the consumer there and posted record earnings just a couple of years later. Even the 2008 recession and financial crisis couldn't put a stop to its slow and steady growth.
The predictability and safety of the stock makes it more like a safe bond than common stock because all one has to do to get their initial investment back is to wait for Wall Street to stop freaking out about irrelevant events and go back to focus on the fact that the Coke brand is growing and increasing its moat decade after decade.
Is the stock a buy today? A Buffett style valuation
Warren Buffett is known for being skeptical for conventional valuation models that rely on GAAP such as price to earnings ratio and the like. He defined one of his methods in the 1986 Letter to Shareholders:
These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges...less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include plus - but do not subtract .
Using his definition I built an excel spreadsheet and calculated Coke's free cash flow/owner's earnings (I took operating cash flows and subtracted that year's capex, since I used a long sample this should be similar to Buffett's approach of using an average of capex) since 1991 (Edgar SEC data only goes back to 1994 for KO which enabled me to get data from 1991 as it was shown in the annual 10-K).
With that data I calculated the growth in Coke's free cash flow. The result was 17% average growth rate a year or 10% compounded per year. In order to value the stock I made a few assumptions:
- I decreased Coke's free cash flow by 15% as a starting value in the valuation to take into account for cashflows that are not available to shareholders due to costs such as non-recurring losses, litigation, restructuring charges, and other non-operating costs, etc. This is in line with Buffett's skepticism that measures are often too high due to a lack of subtractions and it provides a margin of safety against unexpected costs and cash charges.
- Coke's required return (called cost of capital in the spreadsheet) is 5.62% using CAPM: risk free rate 30 year UST yield + beta(market return - risk free rate) 2.94% + 0.38(10%-2.94%) = 5.62%.
- Coke will enjoy another 20 years of similar growth (I used 8% per year growth in free cash flow to be conservative instead of the historical 10% since 1991). This 'growth period' represents increased globalization and the Coca-Cola brand increasing dominance.
- After that I assumed a 5% per year increase in free cash flow into infinity as the company growth slows due market saturation, fewer opportunities, etc.
World nominal GDP according to the World Bank over the last few decades has been around 7% (3% real growth plus 4% inflation). Let's assume that as globalization slows that goes to 5% into infinity and Coke growth slows down to 5% as well (over the long-term nominal GDP tends to be quite close to nominal earnings growth for most companies). How much is the stock worth in that case?
This DCF model (link to the excel file used with the data and calculations) arrived at a value of $71.34 per share. The issue is that owner's earnings when you are not really the owner of the company can overvalue the company given that you don't really have access to those cashflows (unless they send it back to shareholders by dividends and buybacks but a shareholder can't control the size and timing of those distributions). Usually a control premium is valued at around something like 20-30%. If we deflated the fair value by 25% we would reach the stock price of $53.50 which would represent a 45% increase from current levels.
Using a Buffett style valuation method with some conservative values, Coke's stock is currently undervalued. Too many people seem to be focused on measures such as price to earnings ratio where the stock trades at a premium to the S&P500 but from a true value investor perspective the stock is at 4% owner's earnings yield (assuming 2012 free cash flow is $7B) with a high growth rate which is likely to continue for a number of years, plus it's an extremely safe and stable stock with a long track record.
We rate the stock a strong buy and believe that with a dividend yield of 2.8% it represents one of the most attractive income opportunities present in the US equity markets today especially given that low interest rates in alternative investments.