Answering One of Life's Persistent Questions: Coke or Pepsi?

Which of these high-quality companies is a better buy today?

May 27, 2014 at 12:55PM

High quality, household names, global brands, consistent earnings, and dividends -- Coke (NYSE:KO) and PepsiCo (NYSE:PEP) have it all, but which is a sweeter prospect for investors today?

First off, it's good to know that while both are fundamentally excellent businesses, they do not have as much in common as it appears. Coke is focused on beverages, but Pepsi could easily be seen as Frito-Lay due to its large holding in the snack business. Pepsi gets about one third of its earnings from Frito-Lay, so its success is as much about winning the snack aisle as it is about winning the Pepsi challenge.

To get an idea of the fundamental attractiveness of Coke and Pepsi in terms of delivering quality income, let's look at the metrics for safety, dividend yield, quality, and price.

For safety, let's look at the balance sheet--specifically the debt/equity ratio to see how levered the companies are. Next, we'll check the dividend payout ratios to see if there is room for those to grow. There's no sense in counting on a dividend yield if the company will have trouble paying it.

CompanyDebt/Equity Ratio

Dividend 

Payout Ratio

Coke 0.6 61%
Pepsi 1.1 51%

Source: Morningstar

Coke comes out ahead on balance-sheet safety with a lower degree of debt than Pepsi. Both Coke and Pepsi have safe dividend payout ratios.

Pepsi just announced a 15% hike in its dividend yield, which gives it a forward yield of 3%. Coke's forward dividend yield also sits at 3%. These aren't huge yields but the companies are seriously committed to paying them. Coke has raised its dividend for 52 consecutive years, while Pepsi has raised its dividend for 42 consecutive years. Dividends are not a hobby for Coke and Pepsi.

KO Chart

KO data by YCharts

Turning to quality metrics, operating margins and returns on equity give us a view into what kind of returns for shareholders Coke and Pepsi generate.

CompanyOperating Margin

Return on Equity

Coke 22% 26%
Pepsi 15% 30%

Source: Morningstar

Both Coke and Pepsi generate excellent returns on equity, and this bodes well for continued dividend growth. This metric illustrates that these companies can find attractive opportunities to invest in their businesses. Coke earns an edge on operating margin -- perhaps a simpler focus on beverages scales better.

All of the metrics that we have compared have been quite close to one another, and price is no different. Coke's P/E is 22 and Pepsi's P/E is 20. Both of these companies are priced above the S&P market average. Should this fact worry investors? I do not see it as a major concern to pay a slight premium to the market for an excellent business. After all, Berkshire Hathaway's Charlie Munger has three rules of investing:

  1. A great business at a fair price is superior to a fair business at a great price
  2. A great business at a fair price is superior to a fair business at a great price.
  3. A great business at a fair price is superior to a fair business at a great price.

Given that the P/E ratio of the S&P 500 is 19, paying a little bit more for either of these two companies with very high returns on equity and above-average dividend yields does not seem too worrisome.

Straightforward business models plus excellent metrics should mean that both companies have shots at delivering good total returns for investors over long-term time horizons. So which is a better buy? A case could be made for either (pun intended), but given the simplicity of its business focus on beverages, cleaner balance sheet, and better margins, the vote here goes to Coke.

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Gunnar Peterson owns shares of Berkshire Hathaway and Coca-Cola. The Motley Fool recommends Berkshire Hathaway, Coca-Cola, and PepsiCo. The Motley Fool owns shares of Berkshire Hathaway and PepsiCo and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. 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.

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