Although – with the possible exception of a rum and Coke – Diageo (DEO) and The Coca-Cola Company (KO) do not seem to have much in common, I believe both are excellent companies with many of the same sources of competitive advantage.

Like Coca-Cola, Diageo has a large-scale global distribution network that provides a formidable barrier to entry. In particular, Diageo’s large scale production and global distribution channels give it economies of scale, and the strong brands give the company guaranteed shelf space in stores and bars (at the expense of potential market followers). And retailers have an incentive to reserve shelf space for premium spirits as the retailing margins are higher for these products. Diageo also gains economies of scale in advertising. The following table nicely illustrates Diageo’s scale in advertising during 2008:

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This article is part III of a series on evaluating a company's future prospects.

A common approach to retirement planning is to determine an amount that can be initially withdrawn from a retirement portfolio, and increased each year by the rate of inflation. For example, Monte Carlo simulation might show that someone withdrawing $35,000 a year (in today’s dollars) from a $1,000,000 portfolio with some given asset class allocation would result in a terminal portfolio value after forty years of at least $250,000 in 85% of the simulations.

The problem with modeling a retirement plan based off of a fixed initial withdrawal rate that adjusts for inflation each year is that it does not account for the wide range of potential outcomes. Some of these will be negative outcomes – such as the 15% of outcomes where the afore mentioned portfolio dropped below $250,000 – but others will be positive, in that the portfolio will grow at a higher rate, making the initial 3.5% withdrawal rate effectively fall over time.

Estimating a company’s level of recurring capital expenditures is an important component of company analysis, being used to calculate both free cash flow and “owner earnings”, a concept discussed by Warren Buffett in some of his past annual reports.

Free cash flow is calculated as cash flow from operations adjusted for non-recurring items less recurring capital expenditures, whereas owner earnings is calculated as earnings adjusted for certain non-cash items, plus depreciation, less recurring capital expenditures (see Berkshire's (BRK.A) 1986 AR).

In my last article, I wrote about the importance of assessing a company’s competitive position, with a strong competitive position giving us more confidence that a company’s demonstrated earnings power will persist into the future. In this article I am going to describe how I quantify a company’s demonstrated competitive advantage through an analysis of the company’s operating history.

When evaluating a company’s operating history, I assume that a sustainable competitive advantage will allow a company to consistently:

For FY09 and Q409 (note that Procter & Gamble’s (PG) fiscal year ends in June), organic unit volume fell 2% and 4% respectively, while organic sales rose 2% for FY09 and fell 1% for the quarter. With the impact of currency, sales fell more, but the dollar can’t continue to rise forever. Despite the slight drop in revenue from Q408 to Q409, they still managed to grow diluted EPS from continuing operations and adjusted for non-recurring items by 6% (including non-recurring times, EPS fell 11%). Although the market seemed to be disappointed with Procter & Gamble's Q4 earnings, I am still bullish on the company, believing it to have better than average long-term prospects.

First of all, I would hardly call their performance poor, considering we are in the middle of the worst recession since the 1930’s. P&G’s results appear to be stellar compared to that of the S&P500 – looking at S&P’s latest spreadsheet (with 88% of companies having reported), 77.3% of companies are reported lower sales this quarter as compared to the same quarter in 2008. Overall, weighted sales of the SP500 are 20% less than in the previous quarter, and operating earnings per share is 19% lower.

In a previous article I described how to compute a company’s sustainable earnings per share and use this along with the company’s long-term issuer credit rating to estimate the intrinsic value of the company’s shares. Sustainable earnings are a useful quantification of a company’s demonstrated earnings power, but what assurance do we have that the company’s earnings power will persist into the future? None really, as there are many forces external to a company that can cause its earnings power to diminish over time, at no fault of the company’s management (incompetent management being yet another cause of diminishing earnings power). A common cause of diminishing earnings power is competition. If a company does not have a competitive advantage, then when new entrants into the company’s industry increase supply and push down prices, the company must lower its prices, or risk losing market share. Similarly, the introduction of substitutes can reduce demand for a company’s product. Both scenarios will typically cause a reduction in a company’s earnings. Earnings are also impacted by the relative bargaining power of buyers and suppliers, and the intensity of industry competition.

So although our estimate of a company’s intrinsic value – in the absence of selection bias - is probably accurate on average, a company’s actual perfect foresight intrinsic value will vary considerably from our estimate, and will often be quite a bit lower (it will also often be quite a bit higher, but in that case, we probably won’t complain). We can compensate for this in a couple of ways. First of all, we can gain a margin of safety by purchasing a company’s shares at a significant discount to their intrinsic value. For example, if we only purchase the shares of a company that is trading at a ratio of intrinsic to market value of 1.5, then even if our estimate of the company’s intrinsic value is optimistic by 50%, we still end up purchasing the shares at a price equal to their perfect foresight intrinsic value, and obtain a real 5.5% rate of return (5.5% being our inflation-adjusted discount rate). Still, with the inherent uncertainty concerning a company’s future earnings power, and the fact that we introduce selection bias via non-random stock selection, how do we know that even this much margin of safety is adequate?

Business Summary

Coca-Cola is a global manufacturer, distributor, and marketer of non-alcoholic beverages. Coca-Cola sells syrups and concentrates to authorized bottling and canning operators. Coca-Cola has equity stakes in 20% (by volume) of these operators.

In my last article I discussed the importance of evaluating the ability of a company to service all claims senior to common shareholders. This first article focused on assessing the ability of a company to service its debt obligations; in this follow up article, we will take a look at how to quantify pension risk, and then end with a brief look at some additional factors that can impair a company’s financial strength.

Pension Risk

When I am considering the purchase of a company’s shares, a major factor in the decision is the company’s financial strength, which I will define as the measure of a company’s ability to service any obligation senior to common shareholders. These senior obligations include debt payments, preferred stock payments, the funding of any pension plan, and rental expense. Clearly, the ability of a company to service these obligations impacts shareholder return, after all, if a company defaults on its bonds, the value of its common shares fall to zero (or something very close to zero). Beyond avoiding bankruptcy, a high level of financial strength gives the additional benefit of a lower and much more stable cost of debt capital.

My starting point in assessing a company’s financial strength is the company’s long-term issuer credit rating, and I rule out any company with less than an investment grade rating. Limiting myself to investment grade companies substantially decreases my risk. To see why, consider the fact that in a study carried out using NYSE data from 1951 to 1998 over half of the companies in existence at the start of a ten year period were out of business by the end of the ten year period (“The level and persistence of growth Rates”, Chan, et al). Now compare this to investing in a portfolio of stocks at the lower end of investment grade (BAA3 credit rating), where over 90% of the companies would still be in existence after ten years.

With the recent surge in the S&P 500 index, I decided to take a fresh look at the SP500’s valuation and estimate the index’s expected return with a ten-year holding period, and then compare this to the expected return from holding 10-year Treasuries and 10-year Treasury Inflation Protected Securities (TIPS). Plugging nine trailing years of SP500 operating earnings and Standard & Poor’s top down estimate of operating earnings for the next four quarters into my valuation model yields sustainable earnings per share of $63.97 and an estimated intrinsic value of $913.83, pretty close to the index’s current (6/10) price of $931.53, and yielding a ratio of estimated intrinsic to market value of 0.98.

I introduced my valuation model in a previous article; in a nutshell it takes 9 trailing years of earnings adjusted for non-recurring items and a conservative estimate of next year’s earnings, converts these earnings to today’s dollars, and then de-trends the resulting time series. Sustainable earnings per share - the average of the de-trended time series – is then used as an input to the valuation model, which uses a real (inflation adjusted) 5.5% discount rate. For the SP500, I used Standard & Poor’s operating earnings as an estimate for earnings adjusted for non-recurring items. Although Standard and Poor’s operating earnings do not adjust for all non-recurring items, it gets us close enough.

One risk to the competitive position of pharmaceutical companies like Johnson & Johnson (JNJ), Pfizer (PFE), and Novartis (NVS) is a potential increase in buyer bargaining power if the United States moves to a single payer health care system similar to many countries in Europe. We can get an idea of how this might affect pharmaceutical prices by looking at sales in Europe and other countries with single payer health care systems.

A report complied in 2003 (“Prices and Availability of Pharmaceuticals: Evidence from Nine Countries”, Danzon) compiles a price index of pharmaceutical prices in eight different countries as compared to the price in the United States. The countries studied in the report were the United States, Canada, France, Germany, Italy, Japan, and the United Kingdom, Chile, and Mexico.

This article describes a simple valuation model I use to estimate a share’s intrinsic value. A share’s perfect foresight intrinsic value is equal to the total discounted cash that flows from the company to us over the period we own the share, with each cashflow discounted by our required rate of return. These cashflows consist of dividends and the price for which we sell our share at the end of our holding period. It turns out that if we purchase a share for less than its perfect foresight intrinsic value, we will realize a return higher than our required rate of return, and vice versa. The required rate of return, also known as the discount rate, should increase with decreasing certainty regarding an investment’s future cashflows; i.e., the present value of a future cashflow with a given expected value falls with decreasing certainty.

The primary obstacle encountered when estimating a share’s intrinsic value is that unlike an investment-grade bond, where the future cashflows are contractually specified at the time of purchase and are well protected by a large buffer of the company’s earnings, the future cashflows arising from owning a share of a company’s common stock is in many cases completely unpredictable.

Business Summary:

Johnson & Johnson (JNJ) has three business units, all of them focused on healthcare. The pharmaceutical business develops new chemical and biological compounds used in the prevention and treatment of various diseases. The medical devices and diagnostics business develops products used to diagnose and treat various health problems. The consumer health care segment owns many valuable brands such as the J&J baby care product line, Neutrogena, Listerine, and Tylenol.

A company’s reported earnings in a given year can give a misleading picture of a its demonstrated earnings power, which I will refer to in this article as sustainable earnings per share. One source of inaccuracy is that reported earnings will often contain components – such as gains or losses on asset sales, litigation gains and losses, and charges for acquired in process research and development – that are unlikely to be repeated in the future.

Even without the effects of non-recurring charges to earnings, a company’s reported earnings in a given year can be a misleading indicator of the company’s sustainable earnings when the company’s earnings growth is cyclic. The earnings of many companies will tend to follow an industry specific or economic cycle, where profits are lower at the bottom of the cycle and higher at the top; this can sometimes obscure the company’s underlying earnings growth rate (with the effects of the cycle removed). To illustrate, consider the following chart that plots the adjusted earnings per share, revenue per share, end of year price, and price to earnings ratio (using the end of year price) of Caterpillar (CAT).

Business Summary:

Realty Income Corporation (O) is an REIT that focuses on sale-leaseback deals. This is where a business, such as a restaurant or convenience store chain, raises capital by selling the land and buildings used to conduct the firm’s business, but retains the use of the property through a long-term lease.