Introduction
The main aim of this report is to identify and analyze two major companies in the soft drinks industry and make a recommendation on which of them can be considered for investment purposes. The use of various stock valuation models will be applied to quantitatively analyze the financial stability of these companies and their common stock markets performance. All information about the companies is sourced from Edgar and other sites that provide financial information.
Literature Review
Ruback (1995) notes that “Coca-Cola and Pepsi have been rivals in the soft drink market for over a century and both companies enjoy a high degree of brand recognition globally whereby Coca-Cola is the largest manufacturer and distributor of non-alcoholic beverage concentrates and syrups in the world.”
It also has other small businesses under it like; bottling and canning operations. Anuar (2007) observed that “The company (Coca Cola) is a multi-international and all its products are grouped into eight businesses to include: Africa, Eurasia, European Union, Latin America, North America, Pacific, Bottling Investments, and the Corporate.” The products are marketed and sold in more than 100 nations globally and consist of: Coca-Cola, Crush, Sprite, Fanta, Dasani water Fruitopia, Minute Maid juices.
Aswath (2007) notes that “Pepsi is a leading global snack and beverage company; it manufactures, markets, and sells a variety of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods. The company operates in 200 countries outside the U.S. and Canada and gets revenues from four of its major businesses.” Pepsi has also largely benefited from its merges with Frito-Lay and Quaker Oats, by acquiring its businesses, the company revenues have shot upwards a factor that has also led to its stocks gaining value and hence investors can be recommended to invest in Pepsi.
“Coca-Cola’s stock was trading at an average valuation of $45.00 dollars per share in 2003, almost getting to $50.00 dollar, a very high value where it went ahead and shot further to $59.33 in the year 2008. But this can be considered as a drop compared to the $100.00 dollar price range in the 1990’s” (Copeland & Koller, 2000). This drop was caused by the change in consumer preference for carbonated drinks and flavored water. Hence this factor should be a key element for investors intending to invest in the company as it as not shown a significant change to healthier drinks like its counterpart has done.
Pepsi Company has taken a keen strategy on being diverse with their products and has seriously considered the issue of consumer health in production of their products and this has made them be ahead of Coca-Cola in the market for the first time in history (Rosenbaum, 2009).
Pepsi has changed its way of production by reducing production of sugary, fizzy soft drinks and snacks and now only a fifth of Pepsi’s sales now are from these products. The group’s sales growth was twice that of Coca-Cola in 2004, its shares have hit high records this year and have been trading consistently above its rival.
Valuation is a process involving use of several procedures to estimate the economic value of a certain interest in a business. Our major interest in this report is the common stock markets of these two companies but also the company as a whole will be considered. Stock valuation methods are methods used to value stocks, when planning to invest in stocks it advisable not only to know the stock price but also the value. A good model should have the following inputs of valuation so as to achieve the real value:
- Income Statement. A standard income statement should contain revenues, expenses accounts and net income for each operating period of the company this is because dividends are paid from the net income.
- Balance Sheet. The balance sheet contains assets and liabilities accounts, it shows the net worth, shareholders equity or the total assets for the business on the day the report is prepared.
- Discounted Cash Flow Valuation. Also know as a DCF valuation, is the most important part of any professional business valuation model. Cash flows are calculated by adding the net change in certain key balance sheet accounts to net income. They are then discounted by the company’s weighted average cost of capital. The present value of the cash flows (including the present value of the terminal value of the business) is divided by the total number of shares outstanding to arrive at a per share value of the equity of the business (Ross & Jaffe, 1990)
- WACC Calculation. The WACC is the weighted average cost of capital for a firm which is then proportionately weighted. Damodaran quotes that “All sources of capital for example; common stock, preferred stock, bonds and any other long-term debt – are put in a WACC calculation where the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and hence a higher risk.”
- Ratio Analysis. A comprehensive ratio analysis will give you a good summary of the financial stability a company. Some of the important rates are Price earnings ratio, price book ratio, price EBIT ratio, asset turnover ratio, earnings per share (EPS), return on equity, debt-to-equity ratio, interest coverage ratio, return on sales, discounted cash flow, and discounted future earnings. Three of the many stock valuation models are the discount cash flow model, the dividend discount model, and the earnings growth model (Imam & Barker, 2008).
Discounted Cash Flow model
Generation of cash for shareholders is the core business of any company, and hence the more higher its value gets. Levengood (1998) quotes “Free cash flow is slightly different from the net profits that are reported on the income statement hence the need to calculate it by use of financial statements filed by public companies.”
The next step in this model is to estimate the total of future free cash flows from the company, which enables you to express what you think the company’s growth potential is over both the short and long term. The discounted free cash flows are then added all together, and then divided by the current number of outstanding shares to get the stock’s fair value estimate.
Free Cash Flow (FCF) = Cash from Operations – Capital Expenditures (Pablo, 1995).
The method involves converting future earnings to today’s money, and through this method we can get the time value of money and the risk premium. The calculation done according to Pablo are, “future cash flows must be discounted in order to express their present values so as to know the value of a company as a whole, all future cash flows are estimated and discounted to give their present values (PVs) then the sum of all future cash flows, both incoming and outgoing, are subtracted to get the net present value (NPV), which is the value of the cash flow.”
The main inputs in this model are cost of equity, cost of capital internal rate of return – IRR, intrinsic value, the operating income and the equity in earnings and the most essential one, a discounting rate. The weighted average cost of capital is mainly the discounting rate that is used because it effectively shows the risks of the cash flows. The discount cash flow analysis shows changes in the in the long term growth rates have a big effect on share valuation it can also be used by investors to as a reality check instead of using a target price which is a complicated process.
It also provides a bona fide stock value, because it does not weigh all inputs used in the model. The weighted Average Cost of Capital of Pepsi is 5.24% lower than that of Coca-Cola which is 6.35%, this has resulted to the rise its stock value from $40.81 in 1998 to $68.20 while that of Coca-Cola has dropped from $78.38 to $58.7 (McKinsey & Goedhart, 2005).
The model however has its weaknesses such as; it is very mechanical and any minor change in the inputs can lead to major changes in the value. The method also is suited for long term investment and not short-term investing and also it is largely affected by changes in interests rates. This gives us the need to use other valuation methods so as to get an accurate value (Damodaran, 1996).
Dividend Discount model
Rosenbaum (2009) says that; the model is best for income investors because the objective is to project dividend distribution based on the average historical dividend payout ratio and discount it back to the present value; however the stocks must be strong in the market and not penny stocks.
The dividend discount model values stock on the basis of the stock is worth the discounted sum of all dividends in future. James (2006) explains that “The model requires making a lot of assumptions about companies’ dividend payments and growth patterns, as well as future interest rates”. The inputs of this model are current stock price, ratio of net income to total assets, return on equity, expected dividend, rate of return and the expected growth .Using these components, we get the cost of Capital and the growth rate in future dividends.
The argument used in this model is that; the value of a stock is worth of all the future cash flows expected to be achieved by the firm discounted by a risk rate because dividends are the cash flows returned to the shareholder in future and will include dividends and the sale price of the stock when it is sold. The model is best used for stocks that have high yields, and the dividends ought to be paid consecutively for ten years (Aswath, 2001).
Stakeholders invest to get profits hence the most essential quotient in this model is the relation of net income to general equity. This ratio can show us how Pepsi and Coca-Cola are fairing in financial terms: Coca-Cola’s return on equity is 27.0% and that of the industry is (30.7%) while in Pepsi (ROE) is 34.0%, above the industry.
Pepsi is not distributing to the stockholders because of its partnerships overseas while Coca-Cola is not offering as much worth to its stockholders. The other quotient is relation of net income to sum assets that value the return on sum assets after interest and levy fees.
Pepsi’s return on assets ratio in five years is 15.89% a little higher than the that of the industry, that of Coca-Cola is 16.37% once again higher than the indusrty’s14.70%.This is because Pepsi has a long term debt24% while it’s rival has a debt equal to 15.3% of its total liabilities and hence it is safer incase of war or recession than Pepsi. All this factors will assist in getting the dividend yield of these companies for Pepsi its 1.92 (2.90%) (Rosenbaum, 2009).
The Earnings Growth Model
Earnings growth is a measure of a company’ growth in net income over a specific financial period, it can be calculated using pas data or estimated data for future periods. The earnings growth model enables investors to establish the rate of growth of earnings from the stocks invested.
The rate is very important in stock valuation, and some of the inputs used in this model are; dividend pay out ratio, discount rate revenue growth rate, the price earning ratio, and the earning per share. In this model the Price/Earnings to Growth relation which determines the value of stocks while factoring in account earnings growth is established. James, (2006) observes that “The computation is: PEG=price/earnings ratio divided by Annual earnings per share growth.”
Levengood (1998) notes that “Earnings per share is the net income reported in the income statement for a particular period divided by the number of shares outstanding”. In addition, “The theory that is applied here is as the percentage goes above 100% the stock becomes more over valued, and as the ratio falls below 100% it becomes more undervalued. High yielding stocks will always have a higher price earnings ratio because earnings in future are expected to be more”(Rosenbaum, et al 2009).
Price/earnings (P/E) ratios are high for firms with strong increase forecasts, all other factors not considered but they are less for riskier organizations (Aswath, 1996). Pepsi company’s ratio is 19.7 times, lower than the industry’s which is (21.1) while that of Coca-Cola is, 22.1 times high which is well above the industry‘s (21.1) hence its stocks could increase in the future.
However, these companies are both in the soft drinks industry, which has drastically changed in the past decade due to the change of customer’s preferences to healthier drinks as mentioned earlier and hence, Pepsi has a higher probability of its revenues going up and not being affected by this factor, because of its healthier products and so is the growth of the earnings per share of its stocks unlike those of Coca-Cola although it has a higher ratio.
Conclusion
Pepsi appears to have a slight advantage over Coca-Cola because it has better operating margins better revenues and net income which is vital for growing companies. Coca-Cola on the other hand has higher figures but not very attractive margins. Lately Pepsi has also produced good earnings per share statements while Coca Cola has done the same ,they were at a smaller margin.
Coca-Cola has shown very minimal growth in the past five years but still has not it dropped, it is just stagnant a factor not very favorable if at all it intends to attract shareholders. Pepsi on the contrary has shown steady continued growth which is a very attractive factor for investors. Another factor is that both companies have had problems with the emerging markets of India but Pepsi has recently appointed a CEO with an Indian background hence may appear more favorable to the market (James, 2006).
According to my analysis both quantitatively and qualitatively I would consider Pepsi to be a better place to investment in, basing my decision more on the weighted Average Cost of Capital of both companies, the probability of growth of the earnings from their stocks, and the ever changing customers’ needs and preferences. Coca-Cola though should not be dismissed since it’s a sleeping giant that could wake up any time and get back to its position.
To be prepared Pepsi should consider increasing their markets to other regions that the company is not popular for example Africa .Coca-Cola is a strong brand and any investor would consider it for investment but at this point I would advise one to hold and wait maybe in the long term KO which is it’s stock market name may be a glamour stock once again but as for now Pepsi is the sure option.
Reference List
Anuar, Z. (2007). Stock Valuation Model – 3 Simple Techniques to Value Stock. Ezine Articles. Web.
Aswath, D. (2001). Investment Valuation: Tools and Techniques for Determining Value. Burr Ridge, IL: McGraw-Hill/Irwin.
Copeland, T. & Koller, M. (2000). Valuation: Measuring and Managing the Value of Companies. London: Oxford University.
Imam, S. & Barker, C. (2008). The Use of Valuation Models by UK Investment Analysts. European Accounting Review, 4(10), p. 503-535.
James R. H. (2006). Financial Valuation: Applications and Models. New York: Wiley.
Levengood, A. L. (1998). Using Discounted Cash Flow Analysis in an International Setting: A Survey of Issues in Modeling the Cost of Capital. Journal of Applied Corporate Finance, 4(10), 82–99.
McKinsey, K. & Goedhart, W. (2005). Valuation: Measuring and Managing the Value of Companies. Hoboken: John Wiley & Sons.
Pablo, F. (1995). Equivalence of ten different discounted cash flow valuation methods. New York: Harvard University Press.
Rosenbaum, J. P. (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. New York: Cengage Learning.
Ross, W. & Jaffe, I. (1990). Corporate Finance. Burr Ridge, IL: McGraw-Hill/Irwin.
Ruback, R. S. (1995). An Introduction to Cash Flow Valuation Methods. New York: Harvard University Press.