Evaluating Coca-Cola with Relative Valuation

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	(DPS)	7.1
Blend - Credit Suisse 9.7x -Janney 8.9x	April-July	Pepsi Co	(PEP)	9.3
CIBC	July	Cott Corp	(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.

Comments

[Valuecruncher:]

If you are interested - we have some interactive valuation tools that cover KO.

www.valuecruncher.com/...

We have both comparator tools and a DCF tool.

Aug 12 04:47 AM