Drip Portfolio Report
Tuesday, August 5, 1997
by Jeff Fischer (TMF Jeff@aol.com)
and Randy Befumo (TMF Templr@aol.com)

ALEXANDRIA, VA, (August 5, 1997) -- The stock of the leading soft-drink company in the world, COCA-COLA (NYSE: KO), trades at 42 times trailing earnings and the company is expected to grow 18% annually. The average investor argues that the stock is overvalued; in fact, many argue vehemently that it's very overvalued. There's no doubt that the stock is "discovered," but, as they say, "is it too late?"

The second-wealthiest man in the country, Warren Buffett, only bought Coca-Cola ten years ago. The company has become his largest holding. Over the past fifteen years the stock has compounded 30% annually, including reinvested dividends. The past two years have been even stronger. Coke's stock has beat the fast-moving market and returned over 40% each of the last two years. Had you bought Coca-Cola in 1994 you'd be sitting on a 200% gain right now. 200%. And in 1994 Coca-Cola was already an obvious leader with the best brand-name recognition in the world, and had been for years. If the Fool Portfolio had begun by putting all of its money in Coca-Cola on August 4, 1994, at $22, it would be up 209% right now --- compared to it being up 219% currently, but having been a diversified, managed, and sometimes time-consuming portfolio.

With $18 billion in trailing twelve-month sales, Coca-Cola holds 48% of the world's soft drink market, selling more than 160 brands, including two of the world's top-three drinks (Coca-Cola and Diet Coke). Coca-Cola sells in over 200 countries and is doing so more and more efficiently. Remember, not only are we looking for consistent and sustainable earnings and sales growth, but for an increased ability from management to capitalize on that growth, as well. Coca-Cola has done so with impressive dexterity.

The company has grown its return on equity (ROE) from 25% in 1986 all the way up to 60% in 1996. Return on equity measures how much earnings a company generates in four quarters compared to its assets and retained earnings (which is also called shareholders equity).

A high return on equity indicates that a company is generating large profits while having to spend little on capital investments. Coca-Cola fits the bill. The company's business doesn't require constant spending to upgrade equipment, because the syrup-making process doesn't go through many technological advances requiring new equipment. This is good.

Companies sporting a high return on equity are attractive enough to some investors that they use the ROE number and average it with the expected earnings growth in order to determine a fair multiple for the stock. Thus, Coca-Cola isn't valued on earnings alone, but also on its return on equity, and on its return on capital, and the improving margins, too -- in fact, it's valued on the entire business model, as it should be. And that model has been improving consistently.

The company's return on capital (ROC) has improved from 20% in 1986 to 37% last year. Return on capital is found by dividing income from normal operations by the total capital at the company. The more that a company can earn on its capital, the better. It's somewhat like you being able to earn more money at work while sacrificing less of your time, if your time represents your "capital," stockpiled and valuable.

The above valuation numbers improve as a company becomes more efficient. As a company increases sales while keeping all costs down, it increases returns on assets, capital and equity, as well as earnings per share. All of this means improved margins at the same time. Coca-Cola has grown operating margins to 25% and net profit margins to 20%, on average, over the past four quarters. That means that for every dollar of sales, a full 20 cents ends up in Coca-Cola's bank. Ten years ago Coca-Cola was only getting ten cents of every sales dollar to its bank. Yup. The company has improved net margins 100% in ten years.

(For more explanations and definitions regarding valuing stocks, please see "How to Value Stocks" in the Fool's School.)

This is all an impressive past, but what about the future? Where is the extra value in the stock going to come from now? In the company's annual report, Chief Executive Officer Robert C. Goizueta -- who is responsible for much of the success at the company over the past decade -- states,

"This may sound incongruous from one of the world's most valuable companies, about to celebrate its 111th birthday, but, truly, we are just getting started."

Coca-Cola: is it just getting started?

We'll see how that might be true in the Thursday column on Coca-Cola, part two. We'll estimate where Coca-Cola might be in five years.

Contrary to all the Wise out there who say that Coca-Cola is overvalued, I'm aiming to show that Coca-Cola may be one of the best stocks that you can begin to buy right now, if you're investing steadily for the next ten years.

Tomorrow Randy will list exactly what we're looking for in each company, including Coca-Cola, so we can run it and the others through the paces. By the end of the week the Drip Portfolio will step up to the plate for the first time with a purchase decision, if the analysis of Coca-Cola shows what we think it will show. We haven't done that analysis yet. That's exactly what this column is for.

Fool on!

--Jeff Fischer, Fool