After crunching the number for the 4th quarter and full-year financials for The Coca-Cola Company (NYSE:KO), it's very clear the shares are significantly overvalued.
As you can tell by my screen name, I look for things which are obvious. In this case, the shares of Coca-Cola are clearly overvalued and are ripe to fall. To be clear, this is an excellent company which executes very well for its customers and shareholders. The problem is the share price is trading at too high a valuation.
Looking at the simple metrics such as price to earnings (P/E) over the past several years, we can easily realize the mature company, Coca-Cola (which we would expect to trade on a consistent P/E basis), has actually experienced serious multiple expansion. What used to be a reasonable P/E ratio has become 25 to 30 times. Please note all numbers were pulled from the company website and the tables in this article were made in excel by the author. The share prices and EPS are in dollars while the P/E numbers are multiples.
Further, if we look at the dividend history and dividend payout ratios, what we find is alarming. Although the dividend has increased year-over-year, we will notice the payout ratio has also increased along with it - a bad sign. In the following table, the dividend is in dollars (per share), while the "yield as a % is the yield at the high price of the year (lower yield) and the yield at the low price of the year (higher yield). The EPS is in dollars and payout ratio is percentages. The total payout is in millions of dollars.
Clearly, income investors have gravitated to the security as the company can be considered one of the most defensive stocks in the market. Coca-Cola has done a fantastic job of paying and raising dividends for quite some time now.
Continuing on down the list, we look at the return on equity (ROE) of the company and what we find is alarming. The ROE has increased only as a result of increased leverage. Although interest rates have declined and the company has increased the debt in relation to the total equity in the capital structure, the reality is the increase in ROE is not only coming from an increase in leverage, but the increase in leverage is also making up for the decline in asset turnover. It would seem management is not utilizing the company resources as well as possible.
As we can tell, the year 2016 is the beginning of a decline in ROE and a substantial increase in leverage which will probably follow. Although the share price is currently sitting around the $40 range, the reality is the P/E is no better than 25 times forward earnings if all goes well in the coming year.
For the next year, the company is facing a number of headwinds. The first being a very high dividend payout ratio on the heels of a decline in sales and earnings in 2016. The second and more problematic challenge faced by the company is the currency headwinds faced overseas. The currency challenge is one which can strangely sneak up on you and there is very little which can be done.
Lastly, with rising interest rates and a capital structure more dependent on debt, increasing interest rates will have a negative effect on the bottom line. Although the debts will mature gradually, the company may have a difficult time refinancing at the attractive terms offered in the past.
The long-term approach to The Coca-Cola Company is a short position with an exit price of $33. At a current valuation of $40, the upside potential from a short position is 17.5% minus the dividends.
Alternatively, it is possible to make money from the short approach through issuing (writing) in the money call options at a strike of $35 expiring in January of 2018. This options currently sell for a premium of approximately $5.75.
Disclosure: I am/we are short KO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.