Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.
Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheets of Coca-Cola (KO) and PepsiCo (PEP) in order to get some clues as to how well these companies are doing.
I will go through the balance sheets of these two companies, reviewing the most important items, and seeing if there are any major differences between the two that make one a better investment than the other. Information that I used on Coca-Cola can be found here, and information on PepsiCo can be found at this link. Note that this article is not a comprehensive review as to whether either of these two stocks should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.
This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.
As most everyone knows, Coca-Cola manufactures and sells non-alcoholic beverages. Their offerings include soft drinks, flavored waters, carbonated energy drinks, bottled water, juices and teas. They also produce flavoring ingredients, sweeteners, beverage ingredients, and fountain syrups. They also own bottling operations. Some of their most notable brands include Coca-Cola, Diet Coke, Sprite, Fanta, Minute Maid, Powerade, and Dasani.
The company has over 150,000 employees at operations all over the world. 45% of Coca-Cola's sales come from North America, while 13% of sales come from the Pacific region. Europe accounts for 11% of the company's sales, while 10% of sales come from Latin America, and 6% come from Eurasia. 19% of the company's sales come from its bottling investments. Coca-Cola recorded $48B in sales over 2012, and has a market capitalization of $174B.
PepsiCo is also known for its wide array of beverage offerings. However, its offerings are more diversified due to its snack business. PepsiCo's most notable beverage brands include Pepsi, Mountain Dew, Gatorade, Aquafina, 7UP, and Tropicana. Much of their snack business comes from Frito-Lay and Quaker. Brands here include Lays and Ruffles potato chips, Doritos, Tostitos, and Fritos. They are also in the breakfast food arena with offerings like Quaker oatmeal, Aunt Jemima pancake mix and syrup, and cereals like Cap'n Crunch and Life.
PepsiCo is a huge company with almost 280,000 employees. 49% of PepsiCo's business comes from outside the United States. PepsiCo recorded over $65B in sales during 2012, and has a market capitalization of $118B.
Cash and Cash Equivalents
The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.
At the end of 2012, Coca-Cola reported cash and cash equivalents of $16.6B. That's a lot of cash for a company that has a market capitalization of $174B. That means that the company's stock is trading for just over 10 times its cash position, which may make it attractive to value-oriented investors. The company paid out $4.60B in dividends and spent $3.07B on stock buybacks in 2012. In 2012, the company generated $7.82B in free cash flow. Going forward, Coca-Cola has the authorization to repurchase up to 543 million shares over the next several years. For 2013, they plan to spend between $3B and $3.5B on share buybacks. Coca-Cola has increased its dividend payout every year for the last 51 years.
PepsiCo reported $6.62B in cash and short-term investments at the end of 2012. During 2012, the company paid out $3.31B in dividends, and spent $3.22B on buybacks. It generated free cash flow of $5.77B. Going forward, PepsiCo expects to spend $3B on repurchases in 2013, and has announced that a new buyback program will authorize them to buy back up to $10B worth of stock over the next several years. PepsiCo has increased its dividend every year for the last 35 years.
The table below illustrates this information pretty clearly. Coca-Cola trades at a more attractive multiple relative to its cash position. The dividend payouts and share repurchases by both companies over 2012 were covered by their free cash flows.
Dividend Payouts (TTM)
Free Cash Flow
Table 1: Cash Positions and What Coca-Cola and PepsiCo Do With Their Cash
Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.
Coca-Cola had $4.76B in receivables on its balance sheet, equal to 9.92% of its 2012 sales. This percentage was slightly down from the 10.6% of sales that it recorded in 2011, and lower than the 12.6% of sales that it recorded at the end of 2010.
PepsiCo reported $7.04B in receivables, equal to 10.7% of its revenue for 2012. This was inline with percentages of 10.4% and 10.9% for 2011 and 2010, respectively. Given the relatively low percentage of sales that are receivables and the consistency of these numbers over the last couple of years, I don't see anything to worry about here for either of these two companies.
Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.
If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.
The current ratios for both of these companies stand at 1.09, which suggests that both companies have enough current assets on hand to meet their short-term financial obligations in the event of an unlikely disruption to their operations.
Property, Plant and Equipment
Every industry requires a certain amount of capital expenditures. Land has to be bought. Factories have to be built. Machinery has to be purchased, and so on. While much of this is necessary, a company that has to constantly spend money here in order to keep up with its competition may be in a fiercely competitive industry, where it is difficult for anyone to obtain a sustainable competitive advantage. However, it could also work as an advantage in that large investments in this area could present a large barrier to entry to would-be competitors. Whether investments here are a good thing or a bad thing has to be examined on a case by case basis.
Right now, Coca-Cola has $14.4B in property, plant, and equipment on its balance sheet. This figure is inline with the $14.9B that they reported a year ago, and the $14.7B that they reported the year before that. Nearly 70% of their assets in this category are machinery, equipment, and the company's vehicle fleet. 23% of their assets here are in buildings.
PepsiCo reported $19.1B in property, plant, and equipment at the end of 2012. This is inline with the $19.7B that the company reported one year before, and the $19.1B that they reported at the end of 2010. As is the case with Coca-Cola, most of their assets are in machinery, equipment, and the vehicle fleet.
Given that we don't see any huge increases in the capital expenditures of either company in this area, I don't see much to worry about here.
Goodwill is the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case-by-case basis, as good companies are rarely purchased at or below book value.
Coca-Cola has $12.3B worth of goodwill on its balance sheet. This represents just over 14% of the company's total assets. This amount of goodwill is consistent with the $12.2B that they reported at the end of 2011, and the $11.7B that the company reported at the end of 2010. This consistency means that the company hasn't been very busy with making acquisitions over the last couple of years.
PepsiCo has $17.0B worth of goodwill on its balance sheet, which is consistent with the $16.8B that they reported at the end of 2011, but significantly higher than the $14.7B that the company reported at the end of 2010. This increase is due to the company's purchase of The Wimm-Bill-Dann Dairy and Juice Company, which is Russia's leading branded food and beverage company. This acquisition establishes PepsiCo as the largest food and beverage business in Russia. Goodwill right now accounts for nearly 23% of PepsiCo's total assets.
For the reason discussed at the beginning of this section, I generally don't like to see goodwill account for more than 20% of a company's total assets. While this is not a problem for Coca-Cola, I'm a little bit concerned about PepsiCo as they are just over this threshold.
Intangible assets that are listed on the balance sheet include items such as licensed technology, patents, brand names, copyrights, and trademarks that have been purchased from someone else. They are listed on the balance sheet at their fair market values. Internally-developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating their net worth by slapping any old fantasy valuation onto their assets. Many intangible assets like patents have finite lives, over which their values are amortized. This amortization goes as annual subtractions from assets on the balance sheet and as charges to the income statement. If the company that you are researching has intangible assets, with finite lives, that represent a very large part of its total asset base, then you need to be aware that with time, those assets are going to go away, resulting in a reduction in net worth, which may result in a reduction in share price, unless those intangible assets are replaced with other assets.
Coca-Cola reported $15.1B of intangible assets on its balance sheet, accounting for nearly 18% of total assets. However, all but $1B of these assets have indefinite lives, meaning that those assets will not come off of the balance sheet due to amortization. Most of these assets include trademarks and bottlers' franchise rights. The other $1B comes from acquired customer relationships and some bottlers' franchise rights. Their intangible asset total is consistent with what the company reported in 2011 and 2010.
PepsiCo reported $16.5B of intangible assets on its most recent balance sheet, over 22% of the company's total assets. However, all but $1.8B of these assets have indefinite lives, just like most of the intangible assets of Coca-Cola. These intangible assets include mostly brands and franchise rights. The company reported the same number of intangible assets in 2011, but only $13.8B in 2010. The increase in 2011 comes from the brands that the company acquired when it purchased Wimm-Bill-Dann.
Both of these companies reported large totals of intangible assets that represent relatively high percentages of their asset totals. While it's great that most of these assets can't be lost due to amortization, it is still possible that some of them might be written off of the balance sheet, like goodwill, if some of the companies' acquisitions made over the years don't work out like they should. So, in the case of both companies, attention should be paid to how well each company integrates its acquisitions and whether each company is getting the value that it anticipated from these acquisitions.
Return on Assets
The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:
Return on Assets = (Net Income) / (Total Assets).
For Coca-Cola, the return on assets would be $8.68B in core earnings, divided by $86.2B in total assets. This gives a return on assets for 2012 of about 10.1%. This is slightly higher than the 9.4% that was reported for 2011, but a bit lower than the 10.6% that was reported for 2010.
For PepsiCo, the return on assets for 2012 was 8.66%, which is below the 9.66% that it reported at the end of 2011, and also below the 9.79% that the company reported at the end of 2010.
In the table below, you can see how the returns on assets of both companies have changed over the last couple of years. These figures are fairly consistent for both companies, although I give a slight edge to Coca-Cola, because their returns on assets are a little bit higher, and PepsiCo's returns on assets are trending down a little bit.
Table 2: Returns On Assets From Coca-Cola And PepsiCo
Short-Term Debt Versus Long-Term Debt
In general, you don't want to invest in a company that has a large amount of short-term debt when compared with the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.
Coca-Cola is carrying $17.9B worth of short-term debt, but $16.2B of it is commercial paper with an interest rate of 0.3%. Still, this is a lot of short-term debt, and I could see Coca-Cola refinancing a lot of that in the current interest rate environment.
PepsiCo is carrying $4.82B worth of short-term debt, of which $2.9B is original long-term debt that is maturing within the year, and $1.1B is in commercial paper with an interest rate of 0.1%.
Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.
Right now, Coca-Cola is carrying $14.7B of long-term debt, compared with the $13.7B reported at the end of 2011, and $14.0B that was reported at the end of 2010. Of the $14.7B in long-term debt, approximately $8.23B is due within the next five years, with the rest of it not due for another six years or more. The average interest rate on this long-term debt is just 2.1%. During 2012, the company did issue $2.75B of long-term debt with rates between 0.25% and 1.65% and maturities between 2014 and 2018.
PepsiCo currently has $23.5B worth of long-term debt, versus $20.6B from one year ago, and $20.0B from the year before that. Of the $23.5B in long-term debt, $9.7B is due within the next five years, with rates between 1.5% and 5.0%. Much of the rest has rates between 4.4% and 4.8%. During 2012, the company issued nearly $6B of long-term debt for general corporate purposes, including the repayment of commercial paper.
The table below illustrates the long-term debt figures for both companies and how they have changed over the last couple of years.
Table 3: Long-Term Debt At Coca-Cola And PepsiCo
The long-term debts of both companies are moving higher, which is not a positive for either company.
In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of each company's core earnings over the last 3 years. The average earnings of Coca-Cola over this period is $7.98B. The 3-year average for PepsiCo is $6.73B. When you divide the long-term debt by the average earnings of each company, here is what we find.
Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings
For Coca-Cola, here is how it looks: $14.7B / $7.98B = 1.84 years
For PepsiCo, it looks like this: $23.5B / $6.73B = 3.49 years
It appears that each company's long-term debt position is manageable when compared to the earnings power. For the time being, I give the edge to Coca-Cola here because they have lower long-term debt levels. However, this level may rise if the company chooses to move some of that huge short-term debt position over to long-term debt. Also, with most of the free cash flow of each company going to dividends and share repurchases, the companies might need to dig into their cash positions to service some of this debt.
In the equity portion of the balance sheet, you will find the treasury stock. This figure represents the shares that the company in question has repurchased over the years, but has yet to cancel, giving the company the opportunity to re-issue them later on if the need arises. Even though treasury stock appears as a negative on the balance sheet, you generally want to see a lot of treasury stock, as strong, fundamentally-sound companies will often use their huge cash flows to buy back their stock. For this reason, I will usually exclude treasury stock from my calculations of return on equity and the debt-to-equity ratio in the case of historically-strong companies, as the negative effect of the treasury stock on the equity will make the company in question appear to be mediocre, or even severely distressed, when doing the debt-to-equity calculation, when in reality, it might be a very strong company.
Coca-Cola has $35B worth of treasury stock on its balance sheet, while PepsiCo has $19.5B.
The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Coca-Cola and PepsiCo stack up here.
Debt To Equity Ratio = Total Liabilities / Shareholder Equity
For Coca-Cola, it looks like this: $53.0B / $32.8B = 1.62
For PepsiCo, it looks like this: $52.2B / $22.4B = 2.33
The table below shows this figures for both companies over the last couple of years.
Table 4: Debt-To-Equity Ratios At Coca-Cola And PepsiCo
From this, you can see that Coca-Cola has a consistently lower debt-to-equity ratio than PepsiCo, although by itself, it's nothing to write home about. However, this calculation did not strip out the negative effects of either company's huge treasury stock position.
A variation of this ratio that I like to use takes into account the presence of treasury stock on the balance sheets of very strong companies. When there is a large amount of treasury stock on the balance sheet, the regular debt-to-equity ratio can make a very strong company appear as a mediocre, or even a severely distressed company. Here, I add the treasury stock back into the equity, as treasury stock can be re-issued at a later date if the need arises (although you hope that never happens). I call this ratio the adjusted debt-to-equity ratio. It's calculated like this.
Adjusted Debt To Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)
For Coca-Cola, it looks like this: $53.0B / $67.8B = 0.78
For PepsiCo, it looks like this: $52.2B / $41.9B = 1.25
In the table below, you can see how this figure has changed over the last couple of years.
Table 5: Adjusted Debt-To-Equity Ratios Of Coca-Cola And PepsiCo
From this table here, Coca-Cola's debt-to-equity ratios are pretty good and consistently below those of PepsiCo. So, from an overall debt standpoint, Coca-Cola looks to be in better shape than PepsiCo.
Return On Equity
Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.
Return On Equity = Net Income / Shareholder Equity
Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. For this reason, I also strip out the effect of treasury stock here, when I calculate the adjusted return on equity.
For now, let's just calculate the normal return on equity.
So, the return on equity for Coca-Cola is as follows:
$8.68B / $32.8B = 26.5%
The return on equity for PepsiCo is:
$6.46B / $22.4B = 28.8%
In the table below, you can see how the return on equity has fared over the past couple of years for both companies.
Table 6: Returns On Equity From Coca-Cola And PepsiCo
To strip out the negative effects of treasury stock, I calculate what I call the adjusted return on equity.
Adjusted Return On Equity = Net Income / (Shareholder Equity + Treasury Stock)
For Coca-Cola, it comes out as: $8.68B / $67.8B = 12.8%
For PepsiCo, it looks like this: $6.46B / $41.9B = 15.4%
In the table below, you can see how this figure has changed over time for both companies.
Table 7: Adjusted Returns On Equity At Coca-Cola And PepsiCo
From looking at tables 6 and 7, it can be seen that PepsiCo has consistently better returns on equity, meaning that PepsiCo's management is being more efficient with the company's equity.
Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:
Retained Earnings = Net Income - Dividend Payments - Stock Buybacks
On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.
Coca-Cola reported a $58.0B in retained earnings at the end of 2012. This figure compares with the $41.5B that the company reported in 2009. Retained earnings at Coca-Cola grew at a cumulative rate of 39.8% since 2009.
PepsiCo reported $43.2B in retained earnings at the end of 2012. This compares with the $33.8B that it reported at the end of 2009. So, retained earnings at PepsiCo have grown by 27.8% since the end of 2009.
The table below shows how the retained earnings at both companies have changed over the last few years.
Table 8: Retained Earnings At Coca-Cola And PepsiCo
While both companies have shown consistent growth in retained earnings, Coca-Cola has been able to grow them at a faster rate than PepsiCo.
After reviewing the balance sheets of both Coca-Cola and PepsiCo, it can be seen that both companies have a few things in common. They are both generous in their dividend and buyback programs. They have identical current ratios, which are good enough to suggest that both companies will be able to continue meeting their short-term financial obligations in the event of an unlikely disruption of their operations. They also have goodwill and intangible assets that when combined, represent more than 30% of each company's total assets, more than 40% in the case of PepsiCo. While most of these assets won't be lost to amortization, there is the chance that some of these assets might get written off of the balance sheet if some of their acquisitions don't produce their intended values. Close attention should be paid to this.
Coca-Cola, in my view, has the better balance sheet at this point in time due to a larger cash position relative to its market capitalization, slightly better returns on assets, a more manageable long-term debt position, lower debt-to-equity ratios, and better retained earnings growth.
Now, keep in mind, that this doesn't necessarily mean that Coca-Cola is a better overall investment than PepsiCo. There are other things that you need to consider, including the fact that while Coca-Cola is a pure beverage play, PepsiCo has a lucrative snack business. The balance sheet is just one of the many things that need to be considered before making a final investment decision.
To find out more about how I analyze financial statements, please visit my website by following this link. It's a new site that I created for fun, as well as for the purpose of helping others make sound investment decisions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.