- Let's take a look at the upside case for Coca-Cola.
- Coca-Cola has a good combination of strong free cash flow generation and manageable financial leverage.
- We don't expect the 'cola wars' with primary competitor Pepsi to subside anytime soon.
Coca-Cola's (NYSE:KO) shares have been on a steady upward trend as of late. But do they have more upside? Let's examine.
Our methodology starts with in-depth financial statement analysis, where we derive our ValueCreation, ValueRisk, and ValueTrend ratings, which together provide a quantitative assessment of the strength of a firm's competitive advantages. We compare a company's return on invested capital (ROIC) to our estimate of its weighted average cost of capital (WACC) to assess whether it is creating economic profit for shareholders (ROIC less WACC equals economic profit). Firms that have improving economic profit spreads over their respective cost of capital score high on our ValueCreation and ValueTrend measures, while firms that have relatively stable returns score well with respect to our ValueRisk evaluation, which impacts our margin-of-safety assessment.
After evaluating historical trends, we then make full annual forecasts for each item on a company's income statement and balance sheet to arrive at a firm's future free cash flows. We derive a company-specific cost of equity (using a fundamental beta based on the expected uncertainty of key valuation drivers) and a cost of debt (considering the firm's capital structure and synthetic credit spread over the risk-free rate), culminating in our estimate of a company's weighted average cost of capital . We don't use a market price-derived beta, as we embrace market volatility, which provides investors with opportunities to buy attractive stocks at bargain-basement levels.
We then assess each company within our complete three-stage free cash flow to the firm (enterprise cash flow) valuation model, which generates an estimate of a company's equity value per share based on its discounted future free cash flows and the company's net balance sheet impact, including other adjustments to equity value (namely pension and OPEB adjustments). Our ValueRisk rating, which considers the underlying uncertainty of the capacity of the firm to continue to generate value for shareholders, sets the margin of safety bands around this fair value estimate. For firms that are trading below the lower bound of our margin of safety band, we consider these companies undervalued based on our DCF process. For firms that are trading above the higher bound of our margin of safety band, we consider these companies overvalued based on our DCF process.
Let's apply this framework to Coca-Cola.
Our Report on Coca-Cola
- Coca-Cola's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
- Coca-Cola is the world's largest beverage company. The firm owns and markets four of the world's top five nonalcoholic sparkling beverage brands: Coca-Cola, Diet Coke, Fanta and Sprite.
- Coca-Cola has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 40.4% in coming years. Total debt-to-EBITDA was 2.6 last year, while debt-to-book capitalization stood at 49.9%.
- The company boasts a number of competitive advantages: its brands, financial strength, unrivaled distribution system, global reach, and a deep executive bench. Still, we don't expect the 'cola wars' with primary competitor Pepsi to subside anytime soon.
- Coca-Cola boasts a solid dividend. The firm has raised it in each of the past 50+ years, and we expect growth to continue.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital . The gap or difference between ROIC and WACC is called the firm's economic profit spread. Coca-Cola's 3-year historical return on invested capital (without goodwill) is 18.4%, which is above the estimate of its cost of capital of 8.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely
outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Coca-Cola's free cash flow margin has averaged about 17.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Coca-Cola, cash flow from operations increased about 12% from levels registered two years ago, while capital expenditures expanded about 26% over the same time period.
Our discounted cash flow model indicates that Coca-Cola's shares are worth as much as $43 per share at the high end of the fair value range. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Our model reflects a compound annual revenue growth rate of 4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 15.7%. Our model reflects a 5-year projected average operating margin of 51.4%, which is above Coca-Cola's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For Coca-Cola, we use a 8.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $36 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Coca-Cola. We think the firm is attractive below $29 per share (the green line), but quite expensive above $43 per share (the red line). The $43 mark represents the high end of the fair value range, our estimate of Coca-Cola's upside case. The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Coca-Cola's fair value at this point in time to be about $36 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Coca-Cola's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $43 per share in Year 3 represents our existing fair value per share of $36 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.