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Relative valuation of Coca-Cola

I bought KO in 2005 and sold it in 2007. Since last September, the sentiments have grown significantly darker on KO. For example, in Dec 2007 Morningstar rated KO as a 4 Star stock at $51, and gave it an intrinsic value of $64. However, at the current price of $49, KO is a 3 star stock, with an intrinsic value of $55, despite an overall improvement in the business. The focus of this article is to use the relative valuation method to evaluate KO, with the underlying objective of finding out if Coca-Cola is cheap to buy, and calculating the price to buy this blue-chip stock.

In Relative Valuation, the worth of an asset is derived from comparing it against a benchmark. It is similar to the process of buying a house. We derive the buy price from a few sources: we can compare the price against what was sold previously adjusted for inflation; we can also compare the price against the houses with similar characteristics and features, lastly, we can compare it against prices in the neighborhood.

Relative Valuation is different from Cash flow valuation where the value of an asset is the sum of the future cash flows that is generated from the asset discounted to the present. In the example of the house buying, the buy price using the cash flow method could be calculated as the sum of all the monthly rental income that could be derived discounted back to the present. (also referred to as the Bird in Hand principle, a rental income of $1000 upfront is worth more than a $1000 rent income two years from now)

Some of the common ratios are listed below.

Ratios

Suitable for

Issues

Who uses it

Comments

Price / Earnings

(PER)

Most companies

Does not work with Cyclical companies, and may give false sense of cheapness.

John Neff, Peter Lynch

Earnings should be consistent.

Price / Sales

(PSR)

Small companies that are not profitable yet.

Can’t ignore profitability or cash flow forever.

Charles Royce

Revenue is more predictable than Earnings.

Price / Book

(PBR)

Industrial companies, Financial services ccompanies.

Not suitable for asset light companies: high-tech, brand-heavy.

Walter Schloss

Most conservative

EV/EBITDA

Comparing multiple companies with different depreciation methods.

Usually forward EBITDA are used, which are estimates and not actual earning.

Wall Street

Data may not be readily available.

Dividend Yield

Companies who distributes consistent dividends

Very narrowly focused

Only me

Useful as confirmation ratio.

The two questions critical in relative valuation are:

a. Which ratios are relevant for Coca-Cola ?

Some ratios are more suitable than others. The popular ratios and their usage are highlighted below:

I would select Price to Earnings Ratio (PER), and Dividend Yield as the two common valuation ratios for Coca-Cola. I would use EV/EBITDA if I have access to data of Coca-Cola and its peer companies.

Coca-Cola

Values

Comments

Source

P/E Ratio

18.30x

Trailing12 months

Morningstar

Dividend Yield

3.20%

Trailing12 months

Morningstar

EV/EBITDA

12x

FY 2009

See below

Source of Data

EV/EBITDA 2009 Estimates

Date

Credit Suisse

12.2

21st July

Deutsche Bank

11.8

21st July

Average

12x

b. Which benchmark should the ratios be compared against?

The three most common benchmarks are historical values, overall market values and lastly comparisons against similar companies in the same industry. Each has pros and cons, ideally we want a stock that is cheap against all three benchmarks. There are usually reasons why a stock is cheap, perhaps it is because of pessimism affecting the whole industry, sometimes there is a sell-off in the broader market affecting all stocks, sometimes the issues are specific to the company. What we should look for are temporary problems depressing the share price, problems that do not result in a permanent loss in the business dynamics.

Benchmark

The Ratios Relevant

Comments

Historical Ratios

PER, Dividend Yield,

Comparing against historical company P/E ratio

S&P 500

PER,

Comparing against the overall market

Peer Group

PER, EV/EBITDA

Comparing against peer companies.

Relative Valuation is based on the concept of the Reversion to the Mean. If a stock has been selling at an average of 23.8 times earnings for the previous eight years, and it is now selling only at 18.3 times earning with a business model that is still intact, then it is reasonable to expect that the market will recognize this and trade up to the 23.8x times earnings. Of course, one issue with this assumption is that is it rear-mirror looking and not forward looking.

Historic

Benchmark

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

TTM

P/E Ratio

59.5

69.4

29.5

27.4

28.7

20.8

19.8

22.3

23.9

18.2

18.3

Average PER

Signature PER is calculated from 2001 to 2008.

Excluded are 1999 ~ 2000 as the values are outliers

23.83x


Looking at the P/E Ratio, we can see that the trailing twelve months P/E is at a ten year low. Based on this average P/E, Coca-Cola should be valued at 23.83 times Trailing 12 months EPS of 2.70 = 2.7 x 23.83 = $64.34.

Market Benchmark

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

TTM

P/E Ratio

59.5

69.4

29.5

27.4

28.7

20.8

19.8

22.3

23.9

18.2

18.3

S&P 500

28.2

24

23.6

19.8

21.1

19

17.3

16.8

16.5

10.9

17.2

Relative to Mkt

2.11

2.89

1.25

1.38

1.36

1.09

1.14

1.33

1.45

1.67

1.06

Calculating the average Relative Market ratio, we get a ratio of 1.33, excluding 1999 and 2000 outliers. This means the P/E Ratio of KO should be 1.33 times of the S&P P/E ratio, ie. 1.33 x 17.2 or 22.96.

With a calculated P/E ratio of 22.96, KO should trade at 22.96 x 2.70 Trailing EPS or $62 a share.

Dividend Yield is calculated as Dividend Payout / Share Price. Hence, the 3.20% dividend payout in the trailing twelve months can be interpreted as “for every $100 invested in Coca-Cola, the shareholder will receive $3.20 in dividend before taxes”.

The TTM Dividend yield is at the highest for the past ten years. This is due to Coca-Cola increasing its Dividend payout every year (an increase of 11% annually) and as well as a low share price. This validates the P/E ratio that the share price is cheap historically.

Lastly, we complete the Relative valuation by comparing Coca-Cola with its peers.

Peer Comparison

Deutsche Bak

April

Dr. Pepper Schweppes

(NYSE:DPS)

7.1

Blend
- Credit Suisse 9.7x
-Janney 8.9x

April-July

Pepsi Co

(NYSE:PEP)

9.3

CIBC

July

Cott Corp

(NYSE:COT)

4.7

Canaccord Adamss

May

Hansen Natural

(HANS)

10.2

Unweighted Average

7.825

Current KO Multiple

12x

Currently KO trades at 12 times 2009 EV / EBITDA. The FY 2009 EBITDA is calculated from the Deutsche Bank / Credit Suisse blended estimates of 9589m.. If we use the average of the peer group of 7.8x times average EBITDA, then the EV is calculated at $75033.93

EV = Marketshare + Estimated LT Debt – 2009 Estimated Cash

$75033.93 = Market-share + 5,621 – 4500

Market-share = 76,155, Divided by 2319m of shares = $32.8 per Share.

Obviously this is an incorrect metric, either the sample size is too small or we are using the wrong group of peers. The last time Coca-Cola traded at $32.8 was in 1996.

If we regard Cott Corp as an outlier, the target share price of Coca-Cola is $37.1 which still does not trade anywhere near KO in the past 5 years.

Summary

Coca-Cola at the recent price of $49 trades at a discount of about 25% to it intrinsic value of $64 calculated using the P/E Ratio analysis. The Market Benchmark analysis and the Dividend yield analysis reaffirms that the price of Coca-Cola is discounted compared to the S&P Market benchmark and the dividends dished out.

This analysis should be done together with a business analysis as well as other valuation methods like a Discounted Cash Flow. This will give a more complete picture of the investment viability of Coca-Cola.

Disclosure: I do not own any KO shares, I welcome all feedback. You can download a PDF version of this article here.

Source: Evaluating Coca-Cola with Relative Valuation