## Summary

- Coca-Cola’s stock has fallen out of favor YTD.
- Through analyzing its fundamentals, it seems that Coca-Cola is undervalued by at least 15%.
- Coca-Cola’s implied share price is supported by conservative assumptions regarding its top line growth and cost of goods sold, which in turn produces a conservative bottom line.

## Background

Source: Google Finance

As seen above, Coca-Cola's (NYSE:KO) stock has not been doing well recently. It has fallen approximately 7% YTD, while the S&P has been in the green YTD.

This means that market participants are not too happy regarding Coca-Cola's future prospects.

As most of Coca-Cola's beverages are designed to be drunk in a warm weather setting, the unusually cold weather conditions in the beginning of 2014 might had curbed investors' expectations regarding whether Coca-Cola would be able to grow its revenue.

However, weather conditions are not permanent - they change over time. Hence, one can expect weather conditions to improve over time, which would increase demand for Coca-Cola's bottled drinks.

In addition, one should not stray from the fundamentals, which is that a stock should be valued according to its underlying company's **future** earning potential.

This brings us to the most widely-used methodology to value a company's future earning potential - the discounted cash-flow analysis ("DCF").

## DCF

The DCF is premised on the fact that a company should be valued according to the sum of its future free cash flows ("FCF"), discounted to the present with an appropriate discount rate.

To do this, we must first define what FCF is. FCF is defined as the real cash generated by a business's core operations, less its mandatory reinvestment and expenses. Mandatory reinvestment, of course, refers to capital expenditures and working capital, and mandatory expenses refers to taxes - you cannot operate a business without paying taxes.

Mathematically speaking, FCF = EBIAT + Non-cash expenses + Changes to working capital - Capital expenditures

## Historical Financials

In order to form accurate and reasonable assumptions regarding the company's future earning potential, we first need to analyze its historical financials to form a base platform for our assumptions.

Recalling the FCF formula, we need to arrive at EBIAT ("Earnings before interest after taxes").

Now, you may be wondering, why is it before interest, and after taxes?

The reason why we are looking a company's profitability before interest is due to the fact that we are analyzing a company's **unlevered** FCF. Unlevered, in this case, refers to FCF before the payments of interest.

The reason why we are looking at a company's profitability after taxes is due to the fact that taxes are a mandatory expense - you cannot operate a business without paying taxes to the government.

## All figures are in millions of USD, except for per share data.

Source: SEC Filings

As seen above, Coca-Cola's historic revenue growth rate increased by 3.2% from 2011 to 2012, but decreased by -2.4% from 2012 to 2013.

The reason for this decrease in revenue, as stated in their 2013 10-K is due to a decline of sales in Europe, due to poor weather across many countries in the second quarter of 2013, severe flooding in parts of Germany and Central Europe, competitive pricing and weakness in consumer confidence in the region.

As for cost of goods sold ("COGS"), it has hovered around 39.1% to 39.7% of sales in this 3-year period.

By subtracting COGS from revenues, we arrive at gross profit, which has been relatively unchanged at 60.3% to 60.9% of sales.

Source: SEC Filings

As seen above, Coca-Cola's selling, general & administrative expenses ("SG&A") has remained about 36.9% to 37.4% of sales from 2011 to 2013.

As for other operating charges, it has hovered between 0.9% and 1.9% of sales in the recent years.

By subtracting operating charges and SG&A expenses from gross profit, we arrive at operating income which has been steady at about 21.8% to 22.4% of sales in this three-year period.

Source: SEC Filings

As seen above, Coca-Cola's interest income, presumably derived from short-term treasuries has been relatively steady at 1% to 1.1% of sales from 2011 to 2013.

As for interest expense, it has similarly been steady at about 1% (0.8% to 1%) of sales.

Regarding equity income (loss), it has hovered at about 1.3% to 1.7% of sales in the recent 3-year period.

As for other income (loss), it has been about 0.3% to 1.2% from 2011 to 2013.

By subtracting interest expense and adding the above income line items, we arrive at pre-tax income, which has been steady at 24.5% to 24.6% of sales.

Source: SEC Filings

As seen above, Coca-Cola's EBIT ("Earnings before interest & taxes"), obtained through adding interest expense to pre-tax income, and has been steady at 25.4% to 25.5% of sales in this three-year period.

As for income taxes, it has increased from 24.5% to 24.8% of pre-tax income from 2011 to 2013.

By subtracting income taxes from pre-tax income, we arrive at consolidated net income, which has decreased from 18.6% to 18.4% of sales in this period.

By adding depreciation and amortization sourced from Coca-Cola's cash flow statement, we arrive at EBITDA, which has been steady at 29.5% to 29.7% of sales.

To obtain EBIAT, I used the formula: EBIT * (1 - tax rate) to exclude the effects of interest expense as we are analyzing Coca-Cola's FCF on an unlevered basis.

Source: SEC Filings

As seen above, Coca-Cola's historical depreciation and amortization has been relatively stable at 4.1% to 4.2% of sales.

As for stock-based compensation ("SBC"), it has decreased from 0.8% of sales to 0.5% of sales.

As for deferred income taxes, it has similarly decreased from 2.2% to 1.4% of sales.

Regarding equity (income) loss, it has decreased from -0.6% to -0.4% of sales from 2011 to 2013. As income here represents a cash-inflow, we are subtracting equity (income) loss in our FCF calculation.

Source: SEC Filings

As seen above, foreign currency adjustments has been about -0.3% to 0.4% of sales.

As for (gains) losses on sales of assets, it has increased from -0.5% to -1.4% of sales. Regarding this line item, we are subtracting it in our calculation of FCF, to reflect the cash-inflow that it represents with a negative value.

As for other operating charges, it has increased from 0.5% to 1% of sales from 2011 to 2013.

As for other items, it has increased from -0.8% to 0.5% of sales.

Source: SEC Filings

As seen above, Coca-Cola's net change in working capital, or operating assets and liabilities, has decreased from -4.1% to -2% of sales in this three-year period.

As for capital expenditures, it has also similarly decreased from -6.3% to -5.4% of sales from 2011 to 2013.

By utilizing the FCF formula stated in the beginning of this article, we arrive at unlevered FCF values of $7.8bn, $9.2bn and $10bn in 2011, 2012 and 2013 respectively. Thus, from our analysis of Coca-Cola's historical financials, we conclude that they are growing their FCF at a decent rate.

## Projections

Now that we have established a baseline for our projections by gleaning information from Coca-Cola's historical financials, we can form reasonable and conservative assumptions regarding the company's future earning power.

Source: SEC Filings

As seen above, I have projected Coca-Cola's financials for 5 years, as it is incredibly difficult to form accurate assumptions regarding Coca-Cola's growth after 5 years.

I have assumed that Coca-Cola's revenues will decline by 2% in the year 2014, as I feel that poor weather conditions would have a sustained impact on Coca-Cola's profitability for the fiscal year of 2014. For the future years, I have assumed that weather conditions improve, which props up the company's revenue by a small percentage.

As for COGS, as Coca-Cola has disclosed in its 2013 10-K that it faces increasingly competitive pricing, I have assumed an increase in COGS from 39.3% in 2013 to 41% of sales in future years to reflect this.

By subtracting COGS from revenues, we arrive at gross profit, which remains steady at 60.6% of sales and grows from $27bn to $28.1bn from 2014 to 2018.

Source: SEC Filings

As seen above, I have assumed that Coca-Cola's SG&A expenses to be 37.1% of sales going forward. I have obtained this value by taking the average of SG&A expense in the previous 3 years as a percentage of sales, due to its stability.

As for other operating charges, I have assumed it to be 1.5% going forward, a number that I have obtained also by taking an average of the previous years.

By subtracting these line items from gross profit, we arrive at operating income, which remain steady at 22% of sales and increase from $10.1bn to $10.9bn from 2014 to 2018.

Source: SEC Filings

As seen above, I have assumed interest income to remain flat at 1.1% of sales, a value that I have obtained by taking the average of the previous years.

Regarding interest expense, I have assumed it to be 0.9% of sales, also by taking the average of the previous years, due to stability. However, interest expense may increase in future years if Coca-Cola decides to raise capital by issuing debt - a decision that would lower the company's cost of capital by a decent margin, not to mention that Coca-Cola has excess cash flows to support regular interest payments.

As for equity income (loss) and other income (loss), I have assumed them to remain steady at 1.5% and 0.9% of sales respectively, values that I have obtained by taking the average of the previous 3 years, due to stability.

By adding interest income, subtracting interest expense, and adding equity income (loss) and other income (loss) to operating income, I arrive at pre-tax income, which remains flat at 24.6% of sales going forward. Pre-tax income is also projected to increase from $11.2bn to $12.2bn from 2014 to 2018.

Source: SEC Filings

As seen above, I have arrived at EBIT by adding interest expense to pre-tax income. EBIT remains steady at 25.5% of sales, and increases from $11.7bn to $12.6bn from 2014 to 2018.

Regarding the tax rate, I have assumed it to be 24.1%, a value I have obtained through taking the average of the previous years, due to stability. Furthermore, as Coca-Cola has not announced any ventures or investment in operations in new jurisdiction which might affect the company's tax rate, taking the average of the previous years' tax rate seems most prudent.

By subtracting income taxes from pre-tax income, we arrive at consolidated net income, which remains flat at 18.6% of sales going forward, and increases from $8.5bn to $9.2bn from 2014 to 2018.

Regarding EBITDA, I have assumed it to be 29.7% of sales going forward, a value that I have obtained by taking the average of the previous years, due to stability. Furthermore, this seems to be a realistic assumptions as Coca-Cola has not announced any major revision in depreciation and amortization expense calculation, or any major capital expenditure.

To obtain EBIAT, I have used the formula: EBIT * (1 - tax rate), to exclude the effects of interest expense due to the fact that we are analyzing Coca-Cola's FCF on an unlevered basis. Thus, EBIAT remains steady at 19.3% of sales, and increases from $8.8bn to $9.6bn from 2014 to 2018.

Source: SEC Filings

As seen above, for depreciation & amortization, SBC, deferred income taxes, equity (income) loss, significant (gains) losses on sales of assets, other operating charges and other items, I have obtained their percentage of sales values by taking the average of the previous 3 years due to stability.

Regarding foreign currency adjustments, I have assumed them to be 0 as they are extremely difficult to predict.

Source: SEC Filings

As seen above, regarding net change in working capital and capital expenditures, I have obtained their percentage of sales values by taking the average of the previous 3 years' values, due to their stability.

By utilizing the FCF formula, we arrive at FCF values of $8.2bn, $8.4bn, $8.7bn, $9bn and $9.2bn for the years 2014, 2015, 2016, 2017 and 2018 respectively.

## Discounting free cash flow to its present value

Now that we have arrive at FCF values, we have to discount them to its present value with an appropriate discount rate as they are future values.

So, what is an appropriate discount rate? Well, intuitively, the discount rate should reflect the opportunity cost of capital of an investor. This becomes obvious as the investor would logically invest in assets that are equal or more than their opportunity cost, not less. Thus, this opportunity cost of capital will be used as the discount rate.

Before we discount FCF to the present, we have to determine an appropriate discount rate. As unlevered FCF represents the claims that **both** equity and debt holders have to the company, there is a need to separate the discount rate for equity and debt holders.

To calculate the cost of equity, I will be using the capital-asset pricing model ("CAPM"), a formula widely-used by professionals in the finance industry.

CAPM states that, cost of equity = risk-free rate + equity risk premium * beta

To calculate the cost of debt, I will using the weighted-average interest rate on Coca-Cola's outstanding debt as a proxy. Also, as interest expense is tax deductible, we will use the after-tax cost of debt in our calculation of the discount rate.

Source: SEC Filings

As seen above, I have obtained a weighted-average cost of capital ("WACC") of 6.9%, which we will be using as the discount rate.

The equity value that I have used is a market value of equity, or market capitalization, as it more accurately reflects the true cost of equity of a firm.

As for the risk-free rate, I have used the US 30y treasury interest rate as of 2/3/2014. As for the equity risk premium, I have used 8.40%, a number sourced from Ibbotson. Regarding the value of beta, I have obtained it through Google Finance, as of 2/4/2014.

Source: SEC Filings

As seen above, I have discounted Coca-Cola's FCF values to the present, and summed them up. Then, I have calculated the terminal value of the firm, as we assume that the company still continues to operate and exist after 5 years. Then, I calculated the present value of the terminal value, by discounting it to the present, also because it is a future value.

By summing the sum of present of free cash flows and the present value of terminal value, we arrive at Enterprise Value. As a company's stock price is only relevant to equity holders, we have to adjust the Enterprise Value to reflect only equity holders. To do this, we simply subtract net debt, preferred stock and non-controlling interest.

To obtain the implied share price, I divided the equity value by Coca-Cola's fully diluted shares outstanding to obtain an implied share price of $44.23, which represents a 15% discount to the company's current share price of $38.33.

## Are my numbers realistic?

Most of you would be skeptical regarding whether Coca-Cola is in fact undervalued by such a wide margin, and understandably so.

However, keep in mind that my assumptions are extremely conservative and reasonable - increasingly competitive pricing is reflected in increasing COGS, severe weather conditions and its recovery is reflected in revenue growth, et cetera.

Furthermore, as Coca-Cola's interest expense, relative to its FCF is so low (approximately, 5% of FCF), it still has a lot of room to raise debt, thus decreasing its cost of capital, resulting in a higher valuation.

## Conclusion

In conclusion, I conclude that Coca-Cola is undervalued by at least 15%, if not more, due to conservative assumptions regarding its future earning potential, and its capacity to raise external debt to lower its cost of capital, thus creating shareholder value.

My analysis of Coca-Cola on Excel can be found here.

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