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The Coca-Cola Company (KO) has been a solid dividend stock for decades. Its long-term track record is impeccable. Furthermore, Coca-Cola's long-term future looks positive and it is a well established brand; however, there is a possibility that KO is overvalued in the short term. Despite the long-term prospects, this creates the risk of potentially overpaying for the stock.

Dividend stocks have been strong performers through the past five years. In particular, Coca-Cola has returned almost 50% total return since October 2007 - part of this is from an attractive dividend yield (2.7% on a forward basis) and some from earnings growth. However, the multiple has contracted since late-October. On a stand-alone basis, this might be good news; however, the overall macro environment has also changed drastically. It might be better to look at the valuation multiple of KO relative to the overall market. The following graph shows the trailing twelve months TTM PE multiple of Coca-Cola and the SPDR S&P 500 Trust ETF (SPY) that serves as a proxy for the overall market.

Click to enlarge

Source: Author Calculations, Yahoo!Finance for Price Histories, SEC filings, www.ycharts.com, www.multpl.com

The graph compares the two PE ratios and shows the downward trend that is more pronounced in the broader market. The chart below shows the ratio between KO and SPY - which makes it easier to see the relative PE ratios of today and just before the crisis of 2008. Comparisons from late 2008 through 2009 are probably not useful due to substantial losses in the financial sector and weakened earnings in most sectors. These earnings created significant distortion in the multiple that renders comparisons less insightful.

Source: Author Calculations, Yahoo!Finance for Price Histories, SEC filings, www.ycharts.com, www.multpl.com

This chart shows that KO is at its relative peak relative valuation to SPY for the past 10 years. This level was previous seen in summer of 2007 and then in early 2004. The following chart shows the price history of KO.

Source: Yahoo!Finance with daily closing prices

The chart shows that the previous times valuations reached the current highs for TTM PE ratio, preceded meaningful stock price declines. However, it was not necessary for KO's PE ratio premium to be high to signal a potential decline.

This analysis suggests that KO may be due for correction. However, there are also other possible explanations for KO to have such a premium relative to the broader market:

  1. Growth: If KO's long term growth rate is now higher relative to the market than in previous years, a higher relative multiple would be justified.
  2. PE Ratio - TTM vs. Forward: Furthermore, in looking at growth, it is probably more informative to consider forward PE ratios rather than TTM ratios. However, in a stock like KO, which often has pretty consistent growth, the analysis of TTM PE ratios and Forward PE ratios should result in similar, if not the same, conclusions.
  3. Risk: This could be another factor. KO and SPY have difference exposures of overall market risk. KO has a beta of .44 suggesting a lower level of market risk. If this is substantially lower now than in the past, a higher multiple, even relative to the market, could be justified.
  4. Payout Ratio: The final consideration would be payout ratio. A changing payout ratio could impact the relative valuation between KO and SPY. In looking at the dividend discount model, the price of the stock is the future dividend divided by the required return less the long-term growth. The future dividend is just the future EPS multiplied by the payout ratio. The PE ratio is the payout ratio divided by the combined required return less the long-term growth.

This analysis suggests that investors considering an investment in Coca-Cola right now should be cautious in the near term. A price correction might return Coca-Cola to a more attractive valuation. However, it should be noted that this does not impact a long-term outlook on KO. Also, an investor with a long-term horizon and relatively large positions would want to carefully consider the tax implications arising on selling a position. Coca-Cola still pays a good dividend and has a solid record of growth. While investors might experience a decline in the value of their positions, this would not impact the dividend income stream.

Additional analysis should be considered prior to making any investment decision. In upcoming articles, I will look at the four aforementioned considerations that could possibly justify this higher-than-typical premium.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Source: Coca-Cola: An Overvalued Dividend Stock?