Coca Cola -The World’s Easiest Business to Value?

Earlier this week, I bought $65,000 worth of Coca Cola shares at $50 per share, adding to the Coke shares that I bought in 2003 and 2009, for $38 and $45 respectively.

Paying $50 per share represented a fair value to me, but my energetic work-out buddy asked me why…why did I buy Coca Cola?  And why did I throw so much money behind it?

This post is intended to answer his question.

1.  Coke has brand name recognition all over the world, and it has more than 3,300 drinks under its label.   

Yes, you read that correctly:  more than 3,300 drinks.  In North America, Pepsi products can compete with Coke’s, but in nearly every other worldwide country, Coke dominates.  As a world traveller, I see that firsthand, and I marvel at it.

2.  Unlike a company like Apple, Microsoft or any tech company, Coke can increase the price of its products with inflation.  It’s also not significantly affected (as a business) by economic cycles.

For example, breaking Coke’s earnings per share into 3 year chunks dating back to 1985, there isn’t a single 3 year period where the average earnings were lower than they were for the previous three year average.

For example, if you average Coke’s earnings from 1985 to 1987, you get 26 cents per share.

  • From 1988 to 1990 you get 43 cents per share.
  • From 1991 to 1993 you get 72 cents per share.
  • From 1994 to 1996 you get 86 cents per share.
  • From 1997 to 1999 you get $1.45 per share.
  • From 2000 to 2002 you get $1.57 per share
  • From 2003 to 2005 you get $2.06 per share
  • From 2006 to 2008 you get $2.64 per share

My guess is that Coke is the most predictable business in the world. 

And that’s one of the things that makes it easy to value.

3.  Its earnings per share have grown 11.4% annually since 1985; 8.5% annually since 1999; and 7.3% annually since 2004.  Size will always be an impediment to growth, but Coke still has plenty of room to grow as the standards of living increase in the third world—especially in India and China.  And don’t forget, they’re drinking Coca Cola in those countries today, but they’re also drinking loads of Coca Cola products that you and I have never heard of.  Think about those 3,300 drinks again.

4.  Coke is conservatively financed.  Think about this for a moment.  If you were to allocate all of your net salary (after tax) to your debts, including your mortgage, how long would it take to pay everything off?  Of course, that isn’t a practical thing to do (because you have to eat, house yourself etc) but if about 6 months of net earnings could cover it, you’d be in decent financial shape, correct?  For Coke, that’s what we’d be looking at.  Its earnings, if solely applied to net income (after all company salaries and expenses were paid out!) could pay off its long term debt in six months.

5.  Coke doesn’t need to plow loads of money into research and development.  Because of this, it can remain competitive with its products at a relatively low cost, and not have to worry about creating the next, latest tech gadget or pharmaceutical blockbuster.

6.  Its sweet, sugary syrup is cheap.  As such, Coke is hugely profitable.  Its net profit margins are above 20% every year (virtually unheard of) and its return on shareholder’s equity averages above 25% annually as well.  In a nutshell, this means that the business makes a freakish amount of money on very little capital.  It’s very efficient.

7.  Capital expenditures are low.  Think about the money an airline industry or a telecom business has to invest in its infrastructure to remain competitive.  Nobody has to maintain Coke’s products, and they don’t wear out.

8.  They probably have more “customers” than any company in the world.  If you’re a real estate investor, think of it this way:  if you have a single family home rented out, you’re like an aircraft manufacturer (OK, a lot worse) because you only have a single source of revenue.  Likewise, an aircraft manufacturer has very few customers.  As a real estate investor, if you own a triplex or a quad (or an apartment building!) then we’re talking multiple streams of revenue off a single roof.  It’s more efficient.

In business/customer terms, Coke’s customer base is probably the largest on the planet.

9.  Because its earnings are so predictable, it’s easier to put a valuation on it—it’s easier to know what price to pay for its shares.

10.  Coke earns more than 70% of its revenue from overseas.  So if the dollar continues its slide, it continues to be good for Coke.

How did I determine what price to pay for my Coca Cola shares?

There are a couple of different methods here.  First, I looked at Coke’s average level of earnings over the past five years.  It amounts to the following earnings per share levels, and then the average I’ll show you:

  • 2005 = $2.17 per share
  • 2006 = $2.34 per share
  • 2007 = $2.57 per share
  • 2008 = $3.02 per share
  • 2009 = $2.92 per share

The average earnings per share level from 2005 to 2009 = $2.60

If I divide $2.60 per share by the price I paid for my shares ($50 per share) I get an earning yield of 5.2% annually.  If this figure is higher than the rate of a risk free 10 year U.S. government bond, then I’m being offered a premium to hold these shares instead of a bond.  The current U.S. 10 year government bond yield is 3.3%, so Coke is offering me a 57% premium over what a U.S. government bond would pay me.

Many investors choose to look at a single year’s earnings to determine the earnings yield.  In this case, they’d look at $2.92 per share, divided by $50, for an earnings yield of 5.8% rather than 5.2%.  That’s a 75% premium over a government bond yield (5.8 – 3.3 = 2.5 divided by 3.3 = .757)

Doing this (going with a one year example above) might work well for Coke, because of its consistent earnings and growth promises.  But for most businesses, its better to be safe and go with a five year average.  Either way, Coke’s business yield is a lot higher than that of a 10 year government bond.  What’s more is the fact that Coke is nearly certain to make more money over the following three year period, and more money again over the next three year period.  This increases the yield that a purchaser of Coke would be able to enjoy.

But what return can I expect on my investment from Coke?

The future price of a stock is related to two things:

1.  Business earnings

2.  The earnings multiple that investors are willing to pay.

Let me explain the business earnings first.

Coke’s shares, long term, will reflect its business earnings.  If the company makes more money over time, its intrinsic business value will rise over time—thus the demand for the business will reflect in the rising stock price.

Sometimes, dangerous things can occur because investors don’t always tend to be rational.  For example, in the 1990s, the share price increased by 443% (from 1990 to 2000)

But the business’ earnings only increased by 240%.

Anyone who bought Coke between roughly 1995 and 2001 had no business sense.  They bought Coke shares because they were rising in value.  This would have been an expensive education for them.  If they held their shares from 1991 until today, they would have seen their company increase its earnings by 83%—but their shares would still be down about 22%.  The stock market is no place for fools.

That said, Coke isn’t “popular” anymore—which is a good thing for investors.  Yet, it continues to churn out large business products.  At $50 per shares, you’ll pay roughly 17X business earnings.  Think of it this way.  If you had bought the ENTIRE COMPANY, it would cost you about $120 billion.  That cost exceeded Coke’s profits in 2009 by 17 times.  So if you owned 100% of the business, and you paid $50 for every share, it would take the business 17 years to pay for itself, based on last year’s net earnings income.  Of course, earnings will increase over time, that’s a near certainty, but this is how we come to the conclusion that Coke is trading at 17X earnings.

Foolish people were paying more than 55X earnings in 1998.  And of course, if those people still own the shares they paid more than $80 for, they’re still down by 40%.

We know that Coke’s growth rate has slowed.  But it’s still growing.  The past 5 years has seen growth of 7.3% annually (2004 to 2009).  It’s a far cry from the average growth rate between 1985 and 2009 (11.4%) but it’s still impressive.

So what of the future?

My guess is that Coke can keep growing at 6% annually for the next 10 years.  Valueline’s analysts seem to think that Coke can grow its earnings per share by a full 26% from 2009 to 2011. 

If that happens, great.  But as investors, it pays to always have a margin of safety.

If Coke’s earnings per share are $2.93 today, and if it grows by 6% annually over the next 10 years, then its earnings per share will amount to $5.25 in the year 2020.

If Coke trades at its current PE level of 17X earnings, Coke’s stock price will be $89.25, ten years from now.

If Coke shares become somewhat popular, and they trade at 22X earnings, Coke’s stock will trade at $115.50 per share.

Of course, prudent investors should always calculate a margin of safety.  That’s what I did by assuming a growth rate of 6% annually for Coke, despite Valueline’s rosy outlook for significant growth over the next few years.  Frankly, I’ve beaten the market over the past decade by ignoring analysts.  Following them and believing them can make you broke in a hurry.

It’s my belief that I should be able to expect roughly a $90 per share price for Coke, ten years from now.  That will give me a 6% compounding annual return on my stock price, and a further 3.5% annual dividend yield, http://finance.yahoo.com/q?s=ko

for a total pre-tax annual return of 9.5% annually.

Scoff at that if you want, but that would turn the $65,000 I invested in Coke last week, into $161,000, ten years from now.

If you want a high probability of a decent return, Coke might be it (if purchased at $50 or below)

What do you think?

 






Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School (2nd Ed. Wiley 2017) and The Global Expatriate’s Guide To Investing: From Millionaire Teacher to Millionaire Expat (Wiley 2015). My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I’m happy to comment on your questions. However, please read the Terms of Use, Privacy Policy and the Comments Policy.

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19 Responses

  1. Well done! I really like your analysis and conservative approach to it. I am not very active on the US side but I definitely look at it.

    When I was in Japan a while back, I was quite surprised to see how many of the tea drinks were from coca-cola. I agree with you that it has a significant hold on many markets in the world.

    Did you ever sell to take profit? (if you don't mind me asking)

  2. Hey Passive Income Earner:

    You're right about Japan.

    And Coke's profit margins there are huge. They make so much money selling directly to the guys owning the vending machines without a middle man. And you're right; they sell all kinds of teas and coffees. I went for a run in Singapore with one of Coke's top Asian guys, and he talked about Coke's profits in Japan with such reverence.

    As for selling, I still own every Coke share that I've ever bought. If my portfolio was a mutual fund, I guess the "turnover" rate would be less than 5% annually. I have sold shares in other businesses when their prices have become unreasonable, but since I've owned Coke, I think it has always traded within a reasonably narrow range of intrinsic value. If it doubled tomorrow, I'd sell. But if it took five years to double, I'd just keep holding because the business value would be a lot higher five years from now than it is today. My investment philosophy is actually pretty boring.

  3. Coke is a great company, I only have one concern. With more and more people moving away from sugar drinks and their artificially sweetened alternatives, I'm scared that even though Coke is well represented with alternatives, other competitors will emerge. I worked for Pepsi a few years ago and they had gotten to the point where only half of their liquid sales were from soda pop.

  4. Andrew Hallam says:

    I can see your point, Financial Uproar. But I look at the company Altria (Philip Morris) as an interesting counter example. First, their big cigarette brand was/is Marlboro. After that, they have a line of equally unhealthy cigarette and smokeless tobacco products with direct links to cancer. And cigarette consumption in the U.S. has dropped steadily for decades now. Yet, I believe that MO, overall, has been the best performing DOW stock since 1975. There are growing economic regions in the world (China, for example, and South America) where they don't give a rat's rear about the health hazards of smoking. As standards of living increase in China, for example, more people are smoking—I know, it's crazy! But Altria hasn't just dealt with the headwind of slower U.S. sales, they've thrived to beat (to my knowledge) the returns of every other DOW stock that was around in 1975.

    Coca cola has a gentler headwind. With 3,300 drinks under its label, it's a huge coffee, tea, fruit juice distributor as well—not including its presence in bottled water. Living a stone's throw from the thriving third world (I live in Singapore) I can tell you that if you tried to tell the average Malaysian, Thai, Indonesian, Chinese person etc. that sugary drinks were bad for you, they'd look at you sideways, take a puff on a locally branded cigarette (which was likely owned by Altria) and give you a somewhat toothless grin. Coke's worldwide sales are still rising, and I think they will continue to rise, regardless of the health consciousness in the U.S. and other Western countries. Plus, Coke will be there to serve the healthy ones with Minute Maid—which is one of Coke's 3,300 beverages.

    What do you think?

  5. Valid points, especially the Altria example. I still regret not buying either Altria or RJ Reynolds during the early 2000s with all that litigation risk out there. Coke is one of many large U.S. companies that will get the majority of their sales growth from overseas over the next 20 years.

    I am splitting hairs a bit with my criticism with Coke. Long term prospects of the company looks good. I just don't think the Minute Maid or Dasani brands have nearly the moat as the Coke brand does. That adds to the risk of Coke, albeit very marginally. I think your Coke investment is going to do just fine.

  6. Andrew Hallam says:

    Financial Uproar,

    I like the language you're using–referring to Coke itself as having a "moat". You're absolutely right about that. But I wonder, in the future, if their distribution system and deep pockets will create the moat they need on the other products, to keep competitors at bay. Coke and Pepsi probably have a stranglehold on efficient distibution systems, and if a competitor tries a price/advertising war with either Coke or Pepsi, they might be in for a big, expensive disappointment. What do you think?

    As for criticisms of Coke, I'm glad that you're giving me things to think about. It's not that I need to defend my ideas, but only when I can argue the opposing side of any issue convincingly, can I take an educated stand either way. And you're giving me ammunition to counter my Coke argument (although I do know that you think the purchase was a decent one)

    So thank you! And please feel free to keep making me think!

    Andrew

  7. I was in India last year and its unreal how many people you see drinking Coke over there…

  8. Ah my friend, you're warming my heart!

    And when the Indian economy continues to grow….

    This makes me think of something similar. I live in Singapore, so I spend a lot of time traveling throughout SE Asia, and here's what I find: when South East Asians (ie Koreans, Thais, Malaysians etc) gain wealth, they don't covet their own products. They tend to be very brand name conscious, wanting Gucci, Rolex, BMW, Mercedes, Starbucks etc. From what I have seen, as Asia and India grow richer, they'll just make the first world richer in the process. What do you think?

  9. I totally agree. I was vacationing in Singapore and Malaysia in July and couldn’t believe my eyes. Orchard Road was unreal.

  10. @ThinkDividends

    Hey ThinkDividends,

    You noticed all the coveted Western name brand status symbols? I really think that the East's obsession with Western name brands will drag the West up with it.

  11. Dd says:

    Just want to let you know that I really enjoyed your analysis on COKE.

    Just for my clarity: You determine a reasonable P/E by taking a 5 year average and if the current P/E is within that range you see the share price as reasonable and not inflated?

    Also using the government bond yield as a bench–is that just an extra check to make sure the share price is not inflated during current economic situations?

  12. Many thanks for the compliment Dd. To answer your questions:

    1. I take the average of the previous 5 years' earnings, and work out an owner earning yield (the opposite of the PE). For example, if the stock's average earnings were $2 per share, and the stock trades at $40, then the earnings yield is 5% ie. 2 divided by 40 = 0.05. If that yield is higher than a rate on a 10 year government bond (and if the business is predictably going to be generating higher earnings over the following 5 years–which Coke is nearly certain to) then I buy the stock, if the business has a consistently high return on capital, low debt, and all that other stuff I'm concerned about.

    2. I'm not concerned about current economic situations as it relates to the stock. Like Buffett suggests, I look at the business transaction and ignore the economy. If the 10 year bond is yielding 3.5%, and Coke, hypothetically has a 5 year owner earnings yield of 5%, then I'm being compensated for my risk. A government bond is as close to risk free as you'll get. But if I'm going to take extra risk (such as buying an equity instead of a bond) then I want a margin of safety to compensate me for that. A earnings yield of 5% is a 40%increase over a 10 year bond paying 3.5%. For me, that would be more than worth it with a very predictable business, like Coke.

    Note—I just used hypothetical numbers and prices.

    Thanks for the question Dd

  13. Dd says:

    @Andrew Hallam

    Thanks for the in depth reply!

    If you are not concerned about the economic situation and look at the companies true value–do you then use the comparison to government bonds as a risk assessment?

    If the yield was lower than the GB yield would the stock be under performing?

    If the yield was much much higher than the GB yield would you consider the stock much higher risk due to the higher level of compensation?

    Thank you again for taking the time to reply to my comments. My wife and I are both teachers and I am always looking for new insights on stock analysis.

  14. @Dd

    Hey Dd,

    I do compare the yield to government bonds as a comparative price assessment. And yes, I suppose it relates to risk. I want to know if I'm getting value for my money–and if the yield is higher than the bond yield (with that owner earnings yield conservatively calculated with on a 5 year average) then as an owner of Coke, I'm getting "paid" more to own it than I would a bond.

    If the yield was lower than the bond yield, it would actually mean that the stock was expensive, relative to earnings. Most healthy stock earnings' yields were lower than the rate of government bonds in the late 90s. Their stocks were outperforming their earnings. And this is dangerous when the gap keeps growing—as it did in the late 90s. Ideally, I want to see a business performing splendidly, but the stock of that business not doing much at all. The longer I can see that happening (as long as the business yield is higher than a 10 year bond) the happier I'll be. Eventually, the stock will get yanked up to a level on par with business growth. The longer that takes, the better…because it means that you can buy more shares at reasonable prices. You don't want to look for stocks that are "performing well". You want businesses that are performing well….and you want the stocks to be in the doldrums. Then you just need a lot of patience.

    If the owner earnings yield (make sure you're not thinking purely of dividend yield here) is a lot higher than a government bond yield, then the stock is less risky. Calculate the average business earnings yield over 5 years or so, and if it's really high, relative to a bond, and if the company has low debt, high return on capital, a responsible compensation structure for the CEO, a consistent, reliable business model, etc., then you'll have found a gem to keep buying. I wrote, in June, how I bought about $60,000+ worth of Coca Cola at $50 per share. I can't remember exactly how much I bought, but I wrote about it in June. This $50 per share was the most I had ever paid for Coke (I already owned shares that I bought much cheaper) but if you can buy Coke at $50 or below, you should be able to throw a lot of weight and confidence behind it. The cheaper the stock gets (if it drops) the more confidence you should have in the purchase.

  15. Sean says:

    Hi Andrew,

    How do you feel about Coke today? In 2010 you bought for 50 dollars per share but today the value is 40 dollars.
    Is it underperforming your expectations?

    • Hi Sean,

      With all dividends reinvested, Coke share holders have gained roughly 85% since 2010. Remember that when shares grow to a high price, companies often split the stock. You are looking at a current split-adjusted share price of $82 today.

  16. Sean says:

    Interesting. You know, I’m going to start my ETF investments at the end of the Interesting. You know, I’m going to start my ETF investments at the end of the month. But I’ve also been thinking of putting about 10% of my portfolio into coke, Berkshire class B, or both. What say you? At under 50 dollars a share, is coke good value right now?

    • Hi Sean,

      Coke is trading at nearly 22X earnings. That’s far higher than its historical average, and much higher than the market in general. Consider Coke when its PE ratio is 18X earnings or lower. If you buy it now, however, and you are very patient, you’ll still likely do OK over the long term. It’s a great business that can be forgiving over time, even to those that pay too much.

      Cheers,
      Andrew

  17. Sean says:

    Yep, I suspected as much when my wife and I tried to crunch some numbers last night. This is an interesting example of how the price of a share isn’t the important thing.

    Just wondering, though, why specifically is an 18x or below PE ratio the magic number in this particular case?

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