The Long Case For The Coca-Cola Company

Feb.18.14 | About: The Coca-Cola (KO)

The Coca-Cola Company (NYSE:KO) will be announcing earnings on Tuesday, so what better time than the present to get an update on its current valuation. There's not much needed to be said about a company as great as Coca-Cola. It has the number 1 and number 2 brands in terms of sales in Coca-Cola Classic and Diet Coke as well as a huge stable of other recognizable brands in Sprite, Powerade, Vitaminwater, Minute Maid and many more. The Coca-Cola Company closed trading on Friday, February 14th at $38.93 giving a current yield of 2.88%.

DCF Valuation:

Analysts followed by Yahoo! Finance expect The Coca-Cola Company to grow earnings 5.55% per year for the next five years and I've assumed they can grow at 4.5% per year thereafter. Running these numbers through a two-stage DCF analysis with a 9% discount rate yields a fair value price of $44.65. This means the shares are trading at a 12.8% discount to the discounted cash flow analysis.

Graham Number:

The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value. The Coca-Cola Company earned $1.93 per share in the last twelve months and has a current book value per share of $7.28. The Graham Number is calculated to be $17.78, suggesting that it is overvalued by 119.0%.

Average High Dividend Yield:

The Coca-Cola Company's average high dividend yield for the past 5 years is 3.36% and for the past 10 years is 2.64%. This gives target prices of $33.31 and $35.13, respectively, based on the current annual dividend of $1.12. The Coca-Cola Company normally announces a dividend increase in February and I expect the new annual dividend to be at least $1.20 which would mark a 7% increase. This would give forward yield target prices of $35.69 and $37.64 respectively. I'll use the average of all four high dividend yield targets in my target entry price calculation giving an average of $35.44. The Coca-Cola Company is currently trading at a 9.9% premium to this price.

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Average Low P/E Ratio:

The Coca-Cola Company's average low P/E ratio for the past 5 years is 14.95 and for the past 10 years is 16.69. This corresponds to a price per share of $31.09 and $34.72, respectively, based off the analyst estimate of $2.08 per share for fiscal year 2013. Since Coca-Cola will be announcing earnings shortly, let's see how the valuation stands based on the next fiscal year analyst estimate for earnings of $2.21. This gives target entry prices based on the low P/E ratio of $33.04 and $36.88, respectively. I'll use the average of all four low P/E ratios targets giving a target entry price of $33.93. The Coca-Cola Company is currently trading at a 14.7% premium to this price.

Average Low P/S Ratio:

The Coca-Cola Company's average low P/S ratio for the past 5 years is 3.16 and for the past 10 years is 3.48. This corresponds to a price per share of $33.40 and $37.77, respectively, based off the analyst estimate for revenue growth from FY 2012 to FY 2013. Since FY 2013 is over and we're just waiting on the results from Q4, let's see what the price targets are based off the analyst estimate for FY 2014. The price targets don't include effects due to potential share buybacks, rather it's just based off the analyst estimate for revenue and growth, to be a bit conservative. The new price targets based off the estimated revenue growth of 2.90% are $34.37 and $37.77. Currently, their P/S ratio is 3.7 on a trailing twelve months basis. Once again I'll use the average of the four low P/S numbers in my target entry price calculation, giving a target price of $35.56. The Coca-Cola Company is trading at a 9.5% premium to this price.

Gordon Growth Model:

The Gordon Growth Model is a quick way to calculate the fair value of a company using the current dividend, the expected dividend growth rate, and your required rate of return or discount rate. Assuming a constant 6.50% dividend growth rate and a discount rate of 9.00%, the GGM valuation method yields a fair price of $44.80. The Coca-Cola Company is currently trading for a 13.1% discount to this price.

Dividend Discount Model:

For the DDM, I assumed that The Coca-Cola Company will be able to grow dividends for the next 5 years at the lowest of the 1-, 3-, 5- or 10-year growth rates or 15%. In this case that would be 8.06%. After that I assumed they can continue to raise dividends for 3 years at 80% of 8.06%, or 6.45%, and in perpetuity at 6.00%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases. To calculate the value I used a discount rate of 9%. Based on the DDM, The Coca-Cola Company is worth $32.60, meaning it's overvalued by 19.4%.

P/E Ratios:

The Coca-Cola Company's trailing P/E is 20.2 and its forward P/E is 17.6. The P/E3 based on the average earnings for the last 3 years is 19.8. I like to see the P/E3 be less than 15 which The Coca-Cola Company is currently well over. Compared to its industry peers The Coca-Cola Company is overvalued against PepsiCo Inc. (NYSE:PEP) (18.3) and Dr Pepper Snapple Group, Inc. (NYSE:DPS) (16.3). All comparisons are on a TTM basis.


The Coca-Cola Company's gross margins for FY 2011 and FY 2012 were 60.9% and 60.3%, respectively, and they have averaged a 62.7% gross profit margin over the last 5 years. Their net income margin for the same years were 18.4% and 18.8% with a five-year average of 22.2%. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. The Coca-Cola Company is sitting pretty and well above both the 60% gross margin level and 10% net income margin level. I feel it's prudent to make a company to company comparison as well, as each industry allows for different margins. Over the TTM, PepsiCo Inc.'s gross margin was 53% while Dr Pepper Snapple Group's was 58% while PepsiCo Inc.'s net profit margin was 10.2% and Dr Pepper Snapple Group's was 10.4%. The Coca-Cola Company is well above its two largest competitors on both gross margin and net profit margin and is a testament to their operational excellence.

Share Buyback:

Since FY 2002 ended, The Coca-Cola Company has been very solid and consistent in regards to buying back shares. Things started off nicely with an average of 1.1% decrease the first 5 years but then things kind of flat-lined. Management has started to ramp up the buyback program again though. Over the last 10 years, The Coca-Cola Company has decreased the share count by 7.7% from 4,966M to 4,584M good for an average annual decrease of 0.80%. The Coca-Cola Company has at least been fairly consistent in their buyback program, even if it hasn't produced the best results.

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A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.

Dividend Analysis:

The Coca-Cola Company is a dividend champion with 51 consecutive years of dividend increases and most certainly year 52 being announced later this month. They have increased the dividend at a 9.80%, 8.37%, 8.06%, and 9.79% rate over the last 1-, 3-, 5-, and 10-year periods respectively. Dividend increases are based off fiscal year payouts and don't necessarily correspond to annual payouts. Talk about consistency in their dividend growth and something you can depend on. Much different from many of the industrial companies that will have huge double digit increases followed by mid single digit increases. Even if it works out to the same kind of dividend growth over the long haul, The Coca-Cola Company is almost as sure a bet as any to deliver a 7-10% growth year after year. However, that's in the past and there's no guarantee the future will play out the same. Given the expected EPS growth of over 5.55% per year and an average decrease in the share count of 1% per year, Coca-Cola Company could still afford to increase the dividend around the long-term growth rate of 7-9% without increasing its payout ratio. That bodes well for consistent future dividend growth in the short to medium term. The payout ratio has, for all intents and purposes, been flat over the last 10 years. Sure it's oscillated year to year but it's averaged 51.8% over the last 10 years and should end FY 2013 around 50.7%. The dividend is currently well covered by earnings and there's plenty of room to continue to grow the dividend without sacrificing growth of the company.

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Coca-Cola Company's management has done a wonderful job in regards to cash flow. Operating cash flow has increased from $5.46B in FY 2003 to $10.65B in FY 2012 with an average annual increase of 8.42%. Capital expenditures have increased along the way from $0.81B in FY 2003 to $2.78B in FY 2012. Free cash flow has increased from $4.64B in FY 2003 to $7.87B in FY 2012. That's an average annual increase of 7.29%. I like to calculate the free cash flow after paying the dividend as well. While it hasn't grown at quite the levels of operating cash flow or free cash flow it's still increased by 5.56% on average from $2.48B to $3.27B. Dividends are paid from cash so it's important to check the payout ratio based off free cash flow. Over the last 10 years the FCF payout ratio has averaged 55.2% which is a little bit higher than the EPS payout ratio but is still comfortably covered.

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Return on Equity and Return on Capital Invested:

Coca-Cola Company's ROE has averaged a solid 29.7% over the last 10 years while their ROCI has averaged 24.6%. Their ROE has been fairly consistent too, ranging from a high of 38% to a low of 27.1%. ROCI has ranged from 28.4% to 18.9%. The trend for both ROE and ROCI has been slightly negative since FY 2001. I'd love to see those returns start to increase but they are still at pretty lofty levels. This shows the consistency in its operations and their ability to continually earn excellent returns for owners. However, the gap in ROE and ROCI has widened recently due to increased level of debt. Long-term debt has increased 485% since FY 2003 and consequently increased their LT debt-to-capitalization ratio from 15.2% in FY 2003 to 31.0% in FY 2012. It speaks volumes though that despite almost a quintupling in debt, the equity level was able to increase as well to still maintain an adequate debt-to-capitalization ratio. Total debt to equity has increased as well from 0.18 to 0.45 over the same years. The debt is still at manageable levels but more and more of their profit has to go towards servicing the debt instead of going towards growing the business or shareholders' pockets. I'll be watching the debt levels when Coca-Cola reports earnings this week.

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Revenue and Net Income:

Since the basis of dividend growth is revenue and net income growth, we'll now look at how The Coca-Cola Company has done on that front. Their revenue growth since the end of FY 2002 has been solid with a 9.4% annual increase growing their revenue from $19.56B to $48.02 in FY 2012. Their net income growth hasn't quite kept pace with revenue growth leading to a declining net profit margin. Net income has grown at an 8.5% annual rate growing from $3.98B in FY 2002 to $9.02B in FY 2012. Going forward revenue growth is expected to slow down to around 2.9%.

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The chart shows the historical high and low prices since 2001 and the forecast based on the average P/E ratios and the expected EPS values. I have also included a forecast based off a P/E ratio that is only 75% of the average low P/E ratio. I like to the look to buy at the 75% Low P/E price or lower to provide for a larger margin of safety, although this price doesn't usually come around very often. In the case of The Coca-Cola Company, the target low P/E is 15.82 and the 0.75 * low P/E is 11.86. This corresponds to an entry price of $34.96 based off the expected earnings for FY 2014 of $2.21, with a 75% target price of $24.78. Currently Coca-Cola is trading at a $12.78 premium to the 75% low P/E target price and a $2.03 premium to the low P/E price. If you look at the chart you'll notice that the current price line intersects the average forward P/E line around 2014. That's good news for long-term investors and could mean that shares are currently trading at an average valuation as you're not paying for future growth at current prices.


The average of all the valuation models gives a target entry price of $34.97 which means that Coca-Cola is currently trading at an 11.3% premium to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the Gordon Growth Model and Graham Number valuations are removed and the new average is $36.44. Coca-Cola is trading at a 6.8% premium to this price as well.

Assuming that Coca-Cola can grow their earnings and dividends at the rates that I assumed, you're looking at average returns over the next 5 years at current prices. In 2019, EPS would be $2.74 and slapping an average P/E of 18 gives a price of $46.65. Over the next 5 years you'd also receive $7.11 per share in dividends for a total return of 38.1% which is good for a 6.7% annualized rate if you purchase at the current price. If you purchase at the target entry price of $34.97, your projected 5-year total return increases to 53.7% for an annualized return of 9.0%.

According to Yahoo! Finance, the 1-year target estimate is $45.04 suggesting that the share price has about 15.7% upside. Morningstar's fair value estimate is $45.00 suggesting about 15.6% upside and has it rated as a 4 out of 5 star stock meaning it's under their fair value estimate.

The Coca-Cola Company is one of the highest quality companies out there and their continued growth keeps turning owners into millionaires. They've made a killing out of selling what essentially boils down to sugar and water and continue to make billions each and every year. Talk about one of the simplest of core product offerings. The key for them is their brand recognition and distribution network. According to Forbes, The Coca-Cola Company is the number 3 most valuable brand, worth $54.9B, and the only non-technology company in the top 5. In the area of the country that I live you ask for a "Coke" and then clarify what drink you want. How's that for the brand name being front and center in everyone's mind? Their distribution network is so finely tuned that even rival company Dr Pepper Snapple Group has contracted with them for distribution purposes.

Sales volumes across the developed markets continue to decline while international growth has helped to make up for the slack. There's a general trend in the developed markets, the United States especially, for healthier drinks and a shift away from soft drinks/sodas. This has led to the declining volumes and continued weakness over the long term is probably on the way. While PepsiCo and Dr Pepper Snapple reported declining volumes in 4Q13, I'm not sure that Coca-Cola will be following in their steps. Coca-Cola reported an increase in volumes in 3Q13 compared to declines for both PepsiCo and Dr Pepper Snapple. If Coca-Cola reports another increase during 4Q13 then they are taking market share from their two biggest competitors.

The thing I'm most interested in with the earnings announcement is more details on the partnership with Green Mountain Coffee Roasters (NASDAQ:GMCR) and their Keurig Cold system. Few details have been released about the deal other than Coca-Cola is acquiring a 10% stake in GMCR and that GMCR will license and brand Coca-Cola flavors for the Keurig Cold system. The Keurig Cold system is expected to be released in 2015. I'll be hoping for more details on the deal itself and what Coca-Cola's strategy will be moving forward with the GMCR partnership. This could be a potential game changer and help boost the lagging sales volumes in the United States.

Overall I feel that The Coca-Cola Company offers pretty good value at current levels especially since you can front-run the dividend increase. My guess is that the annual dividend is increased to $1.20 giving a forward yield of 3.08%. It's not exactly a steal at current prices but you rarely get companies that are of this high quality to be at fire sale prices. Dividend growth should be able to remain in the 7-9% range over the next few years and the GMCR deal could offer a boost in both earnings and dividend growth in the future.

What do you think about The Coca-Cola Company as a DG investment? How do you think the long-term dividend growth prospects are?

Disclosure: I am long KO. 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 add to my position in the next 72 hours. All charts/images are sourced from my personal stock analysis spreadsheet.