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?