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Yesterday I took a look at Coca-Cola's (NYSE: KO ) third-quarter results and marveled at the overall quality of the company and its brand. I also emphasized the fact that the company is a long-term story -- not one that's worth getting worked up about on a quarter-to-quarter basis -- and it likely has what it takes to deliver on its 10-year plan.
When it comes to actually investing in the stock, though, I was a bit more ambivalent. The current 2010 price-to-earnings ratio of just less than 18 doesn't look particularly cheap, especially in the current market.
But a P/E ratio is always just a starting point for valuation considerations. So today I thought I'd dig in further to figure out what Coke's shares are really worth.
It's a beautiful day in the neighborhood
One way to get an idea of what a stock might be worth is to check out how similar companies are valued. So let's take a look at how Coke stacks up.
Price / Forward Earnings
Total Enterprise Value / Trailing EBITDA
Price / Book Value
|Dr. Pepper Snapple (NYSE: DPS )||13.3||8.9||3.0||1.5|
|HJ Heinz (NYSE: HNZ )||15.6||10.3||7.9||2.2|
|Kraft (NYSE: KFT )||14.9||11.0||1.7||2|
|PepsiCo (NYSE: PEP )||14.6||10.3||5.1||1.6|
|Philip Morris International (NYSE: PM )||14.2||10.2||NM*||1.6|
|Sara Lee (NYSE: SLE )||15.7||7.9||6.4||1.5|
Source: Capital IQ, a Standard & Poor's company, and Yahoo! Finance. Average excludes Coca-Cola.
*Philip Morris International price-to-book value excluded as significant outlier.
Using each of those averages to back into a stock price for Coke, and then taking the average across those results, we can come up with an estimated price-per-share of right around $51. This would suggest today's price of right around $61 is a bit overvalued.
A comparable company analysis like this can sometimes raise as many questions as it answers, though. For instance, is the entire group properly valued? A supposedly fairly valued -- or even overvalued -- stock among a bunch of other undervalued stocks may actually be an undervalued stock, and vice versa.
Additionally, while these companies are comparable they're certainly not all the same. Pepsi and Dr. Pepper Snapple are fellow beverage companies, but Pepsi has its significant snacks business while Dr. Pepper doesn't have nearly the same brand power as Coke. Kraft, HJ Heinz, and Sara Lee, meanwhile, all have brand-driven businesses but with different product mixes than Coke. And while the cynical might say that cigarettes and sugary sodas are very similar, Philip Morris International faces some significant potential challenges -- particularly legal -- that Coke likely does not.
So with all that in mind, it's best to combine comparable company analysis with another valuation technique.
Collecting the cash flow
An alternate way to value a stock is to do what's known as a discounted cash flow (DCF) analysis. Basically, this method projects free cash flow over the next ten years and discounts the tally from each of those years back to what it would be worth today (since a dollar tomorrow is worth less to us than a dollar today).
Because a DCF is based largely on estimates (aka guesses) and it attempts to predict the future, it can be a fickle beast and so its results are best used as guideposts rather than written-in-stone answers sent down from Mount Olympus.
For Coke's DCF, I used the following assumptions:
|2010 Unlevered Free Cash Flow:||$5.9 billion|
|FCF Growth 2010-2014:||8.5%|
|FCF Growth 2014-2019:||4.3%|
|Market Equity as a Percentage of Total Capitalization:||91%|
|Cost of Equity:||12%|
|Cost of Debt:||5%|
|Weighted Average Cost of Capital:||11.3%|
Source: Capital IQ, a Standard & Poor's company, Yahoo! Finance, author's estimates.
While most of this is pretty standard fare when it comes to DCFs, the academically inclined would probably balk at the way I set the cost of equity. In a "classic" DCF, the cost of equity is set based on an equation that uses beta -- a measure of how volatile a stock is versus the rest of the market -- and a few other numbers that I tend to thumb my nose at.
But when you get right down to it, the cost of equity is the rate of return that investors demand to invest in the equity of that company. So I generally set the cost of equity equal to the rate of return that I'd like to see from that stock.
In addition, for some companies -- Coke among them -- acquisitions are a consistent part of the growth strategy. So my free cash flow estimates include an allowance for acquisition spending.
Based on the assumptions above, a simple DCF model spits out a per-share value of just less than $41 for Coke's stock. This seems to confirm that the stock is currently overvalued.
Do we have a winner?
The valuations that we've done here are pretty simple and, particularly when it comes to the DCF, investors would be well advised to play with the numbers further before making a final decision on Coke's stock.
That said, with a price range of $41 to $51, I feel pretty comfortable saying that the stock is currently pretty pricey.
Of course, as I noted above, I set a 12% cost of equity -- aka expected returns -- for my valuation. Investors willing to accept lower potential returns in exchange for the greater stability that a company like Coke provides may find today's price more attractive. For instance, if we adjust the cost of equity down to 8%, then the DCF spits out a fair value of $72.
As for the shares of Coke that I own personally, I'm in no hurry to sell since I think so highly of the company. However, I have no interest in buying at this level and could see myself unloading shares if the price continues to run ahead of the valuation.
Do you think that Coke shares are a better value than I'm giving them credit for? Head down to the comments section and share your thoughts.
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