Coca-Cola Company (NYSE:KO) is a non-alcoholic beverage company. The company owns or licenses and markets more than 500 non-alcoholic beverage brands, primarily sparkling beverages but also a variety of still beverages such as waters, enhanced waters, juices and juice drinks, ready-to-drink teas and coffees, and energy and sports drinks. Coca-Cola Company is a dividend aristocrat that has raised its dividend for 49 consecutive years.
A 10-year summary of Sales, Earnings Before Interest and Tax (EBIT), Earnings per share (EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below.
Key 10-year data for Coca-Cola Company
|Year||Sales (in Millions)||EBIT (in Millions)||EPS||High Price||Low Price||High P/E||Low P/E||Average P/E|
From these data, we can plot Sales, EBIT, and EPS versus Year, as shown in Chart 1 below.
Chart 1. Sales (in Millions), EBIT (in Millions), and EPS versus Year for Coca-Cola Company, 2001-2010
Notice that Coca-Cola has demonstrated extremely predictable sales over the past 10 years, with R squared equal to 0.9533. EBIT and EPS were also quite predictable, except for a large increase in Year 2010. This was due to a one-time, non-recurring income, causing a jump in EBIT and EPS without a proportionate increase in sales. If we exclude the EPS data point for Year 2010, we get Chart 2 shown below.
Chart 2. Sales (in Millions), EBIT (in Millions), and EPS versus Year for Coca-Cola Company, 2001-2010 (excluding EPS in 2010)
Notice how the linear regression fit is dramatically improved for EPS, with R squared equal to 0.9428, significantly better than 0.6777 if the outlier Year 2010 were included. The good linear fit allows us to predict EPS in the near future, say in five years (i.e. Year 2016), using the linear regression equation for EPS = 0.1625 (2016) - 323.85 = 3.75.
A conservative average P/E estimate for the stock can be obtained as follows:
Signature P/E: A well-established stock has a signature P/E, an average P/E it commands in the market based on its business. We calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). The high P/Es in Year 2001-2002 are outliers, so we average the Average P/Es from the other 8 years to arrive at a signature P/E of 20.
High P/E estimate: A conservative high P/E estimate can be calculated by averaging the five lowest High P/Es of the 10 High P/Es from the past 10 years. The 5 lowest High P/Es from the past 10 years are 13.0, 20.1, 22.1, 22.7, and 24.9, which average 20.6.
Low P/E estimate: A conservative low P/E estimate can be calculated by averaging the five lowest Low P/Es of the 10 High P/Es from the past 10 years. The five lowest Low P/Es from the past 10 years are 9.9, 13.3, 16.7, 17.9, and 18.5, which average 15.3.
Average P/E estimate: This takes the average of the High P/E estimate and the Low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 20.6 and 15.3 gives us 17.9.
Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $3.75 * 17.9 = $67.14, which is essentially the same as the current price of $67, which means zero expected return in the stock price in 5 years. When we add in the 2.8% dividend yield, the total return expected is an annualized 2.8%, which means an investment in KO shares today is expected to double in 26 years.
Given a beta of 0.55 for Coca-Cola, a risk-free rate of 2% (using the yield on 10-year Treasury bond as a benchmark), and estimated risk premium of about 5% for the general stock market, we have a discount rate = 2% + 0.55*(5%) = 4.75%. Applying this discount rate of 4.75%, our projected price of $67.14 in 5 years translates to a target price of $53 in today's dollars, which is 15% below the current price of $67 for the stock. For a good margin of safety, investors are well advised to buy only if the current price is at least 20% below the target price, which means a price of $42.
What is the market's expectation of Coca-Cola's growth rate given its current market price equals $67? Since the stock price equals the dividend times the (1 + growth rate) / (discount rate - growth rate), we have growth rate = ((stock price) * (discount rate) - dividend) / (stock price + dividend). Plugging in stock price = $67, dividend rate = $1.88, and discount rate = 4.75%, we get growth rate = 1.9%. This seems low, given that Coca-Cola has grown its revenue by 8.7%, its earnings by 19%, and its dividend by 9.5% annually over the past 5 years. While the growth rate is supposed to slow down a bit as a company matures, a market expected growth rate of 1.9% suggests that the stock is currently undervalued. Assumption of a 3% growth rate for a mature company would price this stock at $111.
Current P/E Compared With Signature P/E
As an additional consideration, we should also determine how the stock's current P/E compares with its signature P/E, since established stocks tend to revert back to their respective signature P/Es over the long term. Current EPS equals 5.43, giving us a current P/E of 12.3. This is only 61% of the stock's signature P/E of 20, which suggests the stock is currently undervalued. In general, we should look to buy when the current P/E is 80% or less of the stock's signature P/E. As a cautionary note, however, the current earnings might be temporarily high, as we have seen for Year 2010, making the current P/E look cheap.
Lastly, we calculate the Risk Index, calculated as (Current Price - Forecast Low Price)/ (Potential High Price - Forecast Low Price) to give an estimate of the risk: Reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.
The Forecast Low Price is calculated by multiplying the Low P/E estimate by the Forecast Low EPS, to give a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past 5 years. For growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate. For Coca-Cola, the forecast low EPS is equal to 3.04, so the Forecast Low Price equals 15.3 multiplied by 3.04 = $46.41.
The Potential High Price is calculated by multiplying the High P/E estimate by the projected EPS in 5 years, giving us a price target in 5 years should the stock command a high P/E. For Coca-Cola, this equals 20.6 multiplied by 3.75 = $77.07.
Thus, the Risk Index = ($67 - $46.41) / ($77.07 - $46.41) = 67%. Since this is significantly greater than 20%, the stock has an unfavorable reward to risk ratio at the current price.
Coca-Cola Company, currently selling at $67, has a target price of $53 and its downside risk outweighs its upside potential. On the other hand, the current P/E of 12.3 is significantly below the stock's historic P/E average of 20, and its market implied expectation of 1.9% appears unreasonably low, suggesting that the stock is currently undervalued. Given these mixed signals, I rate the stock a Hold at the current price, erring on the side of caution. For the more enterprising investor, this stock may be a buy as a long-term investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: Use this information as a starting point for your own due diligence, before buying any stock. If you do buy, be sure to read any annual reports (10-K) and quarterly reports (10-Q) to ensure that the fundamentals remain good and the stock is on target to reach its projected price. After holding for five years, repeat the analysis detailed in the article to decide whether to continue to hold, add, or reduce your position.