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Summary

  • Coca-Cola's earnings have not kept pace with the company's share price.
  • However, the company's shares trade more on dividend yield in my view and right now, shares are far from overvalued.
  • After the recent pullback, KO's dividend is looking pretty juicy.

Investors in Coca-Cola (NYSE:KO) have had a volatile year-and-a-half considering the nature and age of the company's business. Seen as a bond equivalent by some investors and a dividend growth vehicle by others, KO shares often trade at the whims of the interest rate markets or on company specific news, making the job of valuing shares more challenging than it otherwise would be. It's been a while since I've profiled KO and since I'm long, I figured now was a good time to revisit the beverage giant and see if the long thesis was still intact. This is particularly timely considering the violent selloff from the highs of just a couple of weeks ago.

To do this, I'll use a DCF-type model you can read about here. In essence, the model takes inputs such as earnings estimates, dividends and a discount rate to compute a fair value for shares. For this analysis I've used earnings estimates from Yahoo!, a discount rate of 8.5% and a steady payout ratio of 59% for the dividend. The discount rate was arrived at by adding a 6% equity risk premium to the 10 year Treasury, which I use as the risk free rate for these types of models. It's important to understand there is subjectivity in these estimates so your analysis won't look exactly like mine.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.08

$2.08

$2.22

$2.35

$2.50

$2.65

x(1+Forecasted earnings growth)

0.00%

6.70%

6.10%

6.10%

6.10%

6.10%

=Forecasted earnings per share

$2.08

$2.22

$2.35

$2.50

$2.65

$2.81

Equity Book Value Forecasts

Equity book value at beginning of year

$7.77

$8.63

$9.54

$10.51

$11.53

$12.62

Earnings per share

$2.08

$2.22

$2.35

$2.50

$2.65

$2.81

-Dividends per share

$1.22

$1.31

$1.39

$1.47

$1.56

$1.66

=Equity book value at EOY

$7.77

$8.63

$9.54

$10.51

$11.53

$12.62

$13.77

Abnormal earnings

Equity book value at begin of year

$7.77

$8.63

$9.54

$10.51

$11.53

$12.62

x Equity cost of capital

8.50%

8.50%

8.50%

8.50%

8.50%

8.50%

8.50%

=Normal earnings

$0.66

$0.73

$0.81

$0.89

$0.98

$1.07

Forecasted EPS

$2.08

$2.22

$2.35

$2.50

$2.65

$2.81

-Normal earnings

$0.66

$0.73

$0.81

$0.89

$0.98

$1.07

=Abnormal earnings

$1.42

$1.49

$1.54

$1.61

$1.67

$1.74

Valuation

Future abnormal earnings

$1.42

$1.49

$1.54

$1.61

$1.67

$1.74

x discount factor(0.085)

0.922

0.849

0.783

0.722

0.665

0.613

=Abnormal earnings disc to present

$1.31

$1.26

$1.21

$1.16

$1.11

$1.07

Abnormal earnings in year +6

$1.74

Assumed long-term growth rate

3.00%

Value of terminal year

$31.64

Estimated share price

Sum of discounted AE over horizon

$6.05

+PV of terminal year AE

$19.39

=PV of all AE

$25.44

+Current equity book value

$7.77

=Estimated current share price

$33.21

So what does the model tell us? The obvious answer is that the model tells us KO is overvalued on a DCF basis, but in order to understand the result we must understand what the model is implying. By producing a fair value of $33, the model is saying that KO is a good buy at any price under $33.21 today, given the inputs I described above. Since we are trading substantially above that price at this point, we must investigate why and see if it impairs the long term bull case.

As I mentioned in the open, valuing KO is not as simple as other stocks. The company trades not only on company-specific fundamentals but also on interest rate movements. The reason is because KO is a dividend aristocrat and is viewed as a bond equivalent because its earnings are so safe and predictable. Nobody is worried about complex securities on KO's balance sheet blowing up during a crisis and bankrupting the company and the company's very business lends itself to safety and security. Thus, as interest rates move, we often see KO move in response even if there is no company news out that would cause such moves.

So what does this mean going forward? The model says KO is overvalued right now and I'd have to agree. The business is slowing down, as evidenced by the last few earnings reports, and the headwinds for high-calorie drinks, and sparkling drinks in particular, are well-publicized. That said, KO has done an admirable job diversifying away from soda but it is still heavily levered towards that market, of course. This is where I get concerned; analysts are forecasting 6% earnings growth for the next few years but I'm unsure how that's going to happen. KO is famous for returning virtually all of its earnings via dividends and buybacks so that is where the bulk of total returns will come from. The idea of the business growing 6% per year is very optimistic to me as I think we'll see flat to slightly negative growth in the medium term for the business.

That doesn't mean all is lost, it just means we need to readjust our expectations for what owning KO means. KO is highly indebted and the reason is because it wants to make its capital return numbers each year while having to invest in the business. In recent years the business hasn't made enough money to do both so KO has gone to the debt markets to fill the funding gap. I don't think KO's debt level is an issue, or even close for that matter, but in the future if KO continues to borrow heavily we could see dividend growth and/or buybacks slow significantly to service debt.

The bottom line on KO is that it is fundamentally overvalued in my view. However, that has been the case for a while and shares remain elevated. Buy KO if you want predictable dividend growth as this is not a stock where you are likely to see huge appreciation. KO has proven a worthy addition to income portfolios for a century and I don't see that changing. You may have to weather some volatility but you know the dividends will roll in every quarter and that each year will see an increase; you could do much worse.

Disclosure: The author is long KO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Coca-Cola Is Probably Overvalued, But So What?