Philip Morris International, Coca-Cola, and PepsiCo Are Great Investments Because of Shareholder-Friendly Capital Allocation

Philip Morris International, Coca-Cola, and PepsiCo have entrenched competitive positions, but that's not all that makes them great investments. The cash flow statement reveals why long-term investors can feel secure owning each of these stocks.

Feb 15, 2014 at 8:00AM

A company is worth the present value of its future free cash flow. For companies like Amazon.com, investors project future cash flow to be much greater than it is today -- presenting a huge problem for shareholders if it never materializes. However, companies like Philip Morris International (NYSE:PM), Coca-Cola (NYSE:KO), and PepsiCo (NYSE:PEP) generate large sums of free cash flow today and enhance value per share through predictable capital allocation. As a result, shareholders of these companies can be reasonably certain that their investments will do well over time.

Cash conversion is key
For mature companies, cash flow maximization is key to growing shareholder value. The greater percentage of each dollar of revenue that the companies can turn into free cash flow, the more they can reinvest in the business and distribute to shareholders.

Philip Morris, Coca-Cola, and PepsiCo are good at converting sales into free cash flow. Since 2005, each company has turned more than 10% of its revenue into after-tax free cash flow. More importantly, each company generates a predictable free cash flow margin in most years, making it easier for investors to rely on present cash flow to predict future cash flows. Amazon, on the other hand, maintains a single-digit free cash flow margin.

Pm Ko Pep Fcf Margin

Source: Morningstar, author's calculations

The only questions investors need to ask themselves when evaluating these companies are: (1) How quickly will the companies grow revenue in the years ahead, and (2) will the companies continue to turn a similar percentage of revenue into free cash flow? Question one is easier to answer for these companies because they are growing slowly, so predictions are not likely to be off by too much. Question two is simply a matter of determining the companies' respective competitive positions; if each company retains its wide moat, then investors who buy at a low multiple of today's free cash flow will be rewarded -- assuming capital allocation increases shareholder value.

Reinvestment opportunities
Management has two basic options when it comes to capital allocation: reinvest cash in the business or return cash to shareholders. Philip Morris, Coca-Cola, and PepsiCo do a combination of both.

According to corporate finance 101, management should only invest cash in projects that are expected to exceed the company's cost of capital. Projects that offer a high return on investment should get funded, while those that offer a low return on investment should not get funded and the cash should be returned to shareholders.

Philip Morris, Coca-Cola, and PepsiCo are so large that there are not enough high-return projects available to reinvest all of their cash flow. However, the projects in which they do invest have historically generated high returns. If you average each company's return on assets and return on invested capital since 2005, you find that Philip Morris generates a 28% return on investment and Coca-Cola and PepsiCo generate a 17% return on investment.

Pm Ko Pep Roi

Source: Morningstar, author's calculations

Management thinks about investing in projects like investors think about investing in stocks; a 17% compound annual return on investment is really good, so shareholders are rewarded when management invests in these projects.

Share repurchases and dividends
Unfortunately, Philip Morris, Coca-Cola, and PepsiCo are unable to reinvest all of their cash flow at such high rates. Instead the companies invest as much as they can in high-return projects and return the rest to shareholders; since 2008, the majority of each company's cash flow has been returned to shareholders in the form of dividends and share repurchases.

Pm Ko Pep Cfo Returned To Shareholders

Source: Morningstar, author's calculations

Coca-Cola and PepsiCo returned about three-fourths of their cash flow to shareholders. Philip Morris returned more than 100% of its cash flow because it borrowed money at low interest rates and gave it to shareholders. By adding debt to its balance sheet, Philip Morris effectively borrowed future cash flow and gave it to shareholders at present -- thereby increasing shareholder value.

Foolish takeaway
Philip Morris, Coca-Cola, and PepsiCo generate gobs of free cash flow and allocate it in a shareholder-friendly manner. Moreover, the companies produce cash flow today; investors do not have to make assumptions about future cash flow that the companies have not already proven capable of producing. As long as each company maintains its competitive position, shareholders can count on strong investment returns from Philip Morris, Coca-Cola, and PepsiCo.

Three buy and hold stocks to add to your portfolio right now
As every savvy investor knows, Warren Buffett didn't make billions by betting on half-baked stocks. He isolated his best few ideas, bet big, and rode them to riches, hardly ever selling. You deserve the same. That's why our CEO, legendary investor Tom Gardner, has permitted us to reveal The Motley Fool's 3 Stocks to Own Forever. These picks are free today! Just click here now to uncover the three companies we love. 

Ted Cooper's family investment club owns shares of Coca-Cola. The Motley Fool recommends Coca-Cola and PepsiCo. The Motley Fool owns shares of Coca-Cola, PepsiCo, and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers