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Pepsi (NYSE:PEP) and Coca-Cola (NYSE:KO) need no introduction. Both are large beverage companies with Pepsi also owning a foods segment that compiles about 20% of its revenue.

Below is an image of a Return on Equity (ROE) analysis for both companies. ROE is a very important ratio because it compares the profits of a company to the total investment from the shareholders (Contributed Capital + Retained Earnings). Also, it gives investors a measure of the performance of their investment.

(click to enlarge)Coke vs. Pepsi ROE Model

More important than ROE are the components used to create it. To get to ROE, we can multiply Return on Assets (ROA), Capital Structure Leverage (CSL) and Common Equity Leverage (CEL).

Mathematically, this makes sense.

(click to enlarge)

This also makes sense from a logical perspective. Return on Assets measures the efficiency of a company's operations. Leverage can be used to improve ROE (by boosting ROA) because it allows a company to use non-shareholder money to earn profits for the shareholders.

Drill Down

Let's start with ROA. ROA is a measure of how efficient a company is using its assets to generate a return for shareholders. It is a measure of how well a company's core business has been performing. ROA can be broken up into two components: profit margin and asset turnover.

Different strategies - Coke has superior margins, but slower turnover.

Coke's average profit margin for the past two years was 18.61%, while Pepsi's was only 9.56%. The difference is largely due to higher COGS as a percent of sales. Coke's average gross margin is 60.59%, while Pepsi is only 52.22%.

However, Pepsi turns over its assets quicker than Coke. Over the past two years Pepsi has turned over its assets every 399 days, versus Coke's 631 days. This is largely due to Pepsi turning over its inventory every 20.6 days, versus Coke's 24.2 days.

Coke's average ROA the past two years was 11.43%, while Pepsi's was 9.68%. When you multiply Profit Margin and Asset Turnover you get ROA. Coke's strategy of higher prices has proven to be superior to Pepsi's strategy of faster turnover.

The Leverage Effect

Pepsi relies on leverage to keep its ROE high. As explained earlier, leverage can boost ROE because it allows a company to use non-shareholder cash to generate returns for shareholders. Capital Structure Leverage tells us the amount of leverage a firm is taking out, and Common Equity Leverage shows what percent of the leverage is being used to help boost returns for shareholders (versus the debt investors).

Pepsi's CSL is 3.44 versus Coke's 2.55. Furthermore, since 2010, Coke's CSL increased by 18.6% while Pepsi's increased by 21.1%. What is troubling for Pepsi is that only 90.6% of their leverage is being used to generate returns for shareholders compared to 96.7% for Coke.

While leverage improves ROE, it is a double edged sword. The more a firm uses leverage, the more risky that firm is. Moreover, firms can use more leverage to hide deteriorating ROA fundamentals.

Conclusion

While Pepsi has had a slightly higher ROE the past two years (30.9% and 28.8% versus 27.15% and 27.7%), Coke is a better investment. Coke commands a better ROA, and has been using its leverage more efficiently than Pepsi. Pepsi's core business has been on a downtrend and debt reliance has been their crutch to keep ROE at a high level.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate a long KO, short PEP strategy using deep in the money call and put options.

Source: ROE Model: Buy Coke / Short Pepsi