Hansen's Unnatural Valuation

Yesterday, in my review of earnings for Inside Value selection Coca-Cola (NYSE: KO), I mentioned in passing that Hansen Natural (Nasdaq: HANS) shareholders should consider reevaluating their position. A number of folks felt compelled to email me that such a suggestion was bordering on heresy, so I think I owe my Foolish readers a slightly more detailed explanation.

The primary reason I cited was Coke's move to the No. 2 position in U.S. energy drinks. I'll fully concede that being No. 2 can often mean being a distant second. I wasn't trying to argue that Coke will steal Hansen's lunch in the energy-drink business, but that Coke and others have the ability to chip away at Hansen's potential growth. That's dangerous, considering the significant amount of growth priced into Hansen's shares.

Performing a discounted cash flow analysis with a 10% discount rate (generous, in my opinion), and giving Hansen Natural credit for its cash balances and lack of debt, reveals that Hansen has 15% annual growth priced in for 20 years, with 3% growth thereafter. Knocking the initial 20-year growth rate down to 10% and keeping the same terminal growth rate yields a share price of $25, about half what Hansen Natural sells for today.

It's true that Hansen has a much smaller base of free cash flow to start from than Coca-Cola, PepsiCo (NYSE: PEP), or Cadbury Schweppes (NYSE: CSG). That smaller base makes it easier and more likely to achieve above-average growth rates. It's also true that Hansen has a strong balance sheet and other admirable qualities. But ignoring valuation is a dangerous game. If Hansen does achieve the growth that's priced into shares, it will be generating a little more than a billion dollars in free cash flow 20 years from now. That's a hurdle many companies never cross, and in the non-alcohol ready-to-serve beverage business, it's an honor that pretty much belongs to Coca-Cola and PepsiCo.

To buy shares in Hansen today, you need to believe that 15% growth for 20 years is not only possible, but highly probable. That's not an assumption I feel comfortable with making for Hansen, and as a shareholder in Starbucks (Nasdaq: SBUX) for almost eight years, I'm fully versed in the type of dilemma it creates for investors.

I didn't buy Starbucks when it was at one of its peaks in valuation or share price, but I've held it through a few peaks and troughs. I can't say there's a perfect solution to holding a richly valued company, but investors need to be sure they understand exactly what is expected of the companies that they own. Hansen could be another Coca-Cola or PepsiCo, or it could be the next Snapple or Arizona Iced Tea. Paying a rich valuation to find out which company Hansen will become seems like a low-probability bet to me.

Coca-Cola is a Motley Fool Inside Value pick, while Starbucks was singled out for Motley Fool Stock Advisor . Try any of the Fool's market-beating newsletter services free for 30 days.

At the time of publication, Nathan Parmelee owned shares in Starbucks, but had no interest in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.