Coke Is Not A Great Deal Right Now

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 |  About: The Coca-Cola Company (KO)
by: The Dumb Money

Coke (NYSE:KO) is one of the "obvious" investments. We the dumb money, which is what the professionals call you and I, John and Jenny Q. Investor, love this stock. Warren Buffett owns it. We feel smart when buying it. We feel like we won't lose, and yet, unlike with some iconic companies, there is a sense that it is still vital and growing. And in fact, it is still growing. But the reality is Coke is rarely undervalued. That is why I was so psyched to pick a very small amount up during the financial crisis. Now, however, it is not undervalued at all on a discounted free cash flow basis. It is a fair value hold, and a sensible one, but it is not a buy. It's just not a great deal right now.

Cash on hand: Coke has around $14 billion in cash on hand. However, from the same link, it also has $13.656 billion in long term debt. So I don't credit it with any net cash for free cash flow purposes. It also has $14,912 billion in short term debt, from the same link. But for short term debt just ignore it; the company has enough assets from receivables, etc., to cover that, and it's just not relevant to telling you what ultimate cash flows belong to you as the shareholder.

Discount rate: I have struggled with what discount rate to use for companies. Value hounds want you to discount all future earnings at a 15% discount rate. Some people do it by "feel" and assign 10% to safer companies, and 12% to "riskier" companies. I have recently come to the conclusion that the best thing to use is the weighted average cost of capital ("WACC"). Many sites can get you that, but I use this one, which shows a WACC of 7%. That is very low, which helps Coke have a higher valuation (the higher the discount rate, the less money from future years is worth today). In fact, the lowness of that WACC is scary to some people. Think of it as reflecting how warm and fuzzy and safe Coke makes you feel when you buy its stock rather than that of Acme Social Bubble, Inc.

Growth Assumptions: You need yourself some growth assumptions. Discounted free cash flow is deceptively unscientific -- it seems scientific, but is riddled with assumptions. I base mine on prior growth, which I tend to assume will slow to varying degrees moving forward. As reflected on my sheet here near the top, Coke has managed between 5% and 6% annualized free cash flow growth over the last nine years, and it has recently slowed to closer to 5%. Frankly, that is fairly slow growth. It's probably imprudent to assume vastly greater growth than that going forward either (if it shows up, we can change our assumptions).

Conclusions: I have started with the most recent year's free cash flow, of $6.554 billion, to be my growth starting point. Here's the problem. If you assume a 7% discount rate, and growth only equaling the top end of what we have recently seen, or 6%, then he stock is only fairly valued. And that's if you assume a 7% WACC for your discount rate, the really low rate.

If you assume a 10% discount rate, you get a situation whereby Coke is seriously over valued. Now, I like WACC. Since the WACC is 7%, I will use 7% as the discount rate. But the bottom line is that it is very hard to construct a scenario whereby this puppy is a buy. My buy price if $60. My sell price is $90, as reflected on the sheet. At $75.71 as of this writing, this stock is firmly in the "hold" area, but is not a buy. A purchase today is not especially likely to result in superior returns, especially given Coke's low recent growth rate, which is at about average for the S&P index, not superior at all. And forget about a "margin of safety."

I will continue to hold. Coke is far from a buy, on a valuation basis, and is probably only fairly valued at best. That isn't to say it's wrong for your portfolio. Coke is stable. It has a nice and growing dividend. If the market swoons again, it will outperform during that swoon. It is not going to go bankruptcy. It has one of the most powerful and sustainable brands in the world. So maybe you are willing to "pay up" for that. Just know that unless growth picks up significantly from this 6% baseline, you're probably not getting a great deal on a free cash flow per share basis.

Share Repurchasing Note: You will see on the bottom line here that Coke has not been doing any share repurchases in the last five years or so. This is a company a large part of which is owned by Berkshire Hathaway, and Warren Buffett's son sits on the board. It should tell you something that the company is not buying its own shares. If Coke ever starts buying back its own shares, that will be an excellent signal that the company is finally a strong buy.

Disclosure: I am long KO. I have been holding Coke shares since originally purchasing around $45 share during the financial crisis. I added marginally at around $63 some time ago. I have no plans to add any more at this time, but no plans to sell.