To learn why some Fools don't care to invest in the industry at all, visit the Drip Companies discussion board from the past two days. We've held an active dialogue on the issue beginning with the posts titled "Re: Poll: What Should Drip Port Buy?" And if you haven't voted yet, be sure to cast your vote this weekend. Here's the poll.
Now, leading with 53% of the vote, today we'll consider a final factor regarding PepsiCo: its potential return based on a discounted cash flow model.
We have discussed Pepsi's valuation in the past, but we haven't run it through a model of what could potentially happen in the next two decades. As always, discounted cash flow (DCF) models are speculative creatures that assume consistent results of one kind or another. They are almost never entirely predictive, so they are best used as merely suggestive models.
Admitting these limitations, we'll run a loose model over Pepsi just to see where it lands. Last year, we ran similar models on Pfizer (NYSE: PFE) and Johnson & Johnson (NYSE: JNJ) and they showed Pfizer to be very interesting at $32 per share (it's now up 37% to $44) and Johnson & Johnson looked best for us at around $74 per share -- at that price, we have a better chance of achieving a 15% return with J&J. So, we have bought J&J at those prices when possible. (For details on how to run these models, see the past columns: Pfizer and J&J .)
When you run DCF models, the discount rate that you use is typically that same as your expected (or hoped for) rate of return. As we did in J&J's case, we'll make this 15%. You also need to assume your company's long-term growth rate. The next three years are expected to be stronger than usual at Pepsi, but after that we'll go with an 11% rate of growth in its free cash flow. So, the following is our assumed discounted free cash flow value that will be created at Pepsi over 18 years:
Free Cash Discounted
Year Flow Growth Value
2000 $2.176b 14% $1.892b
2001 2.458 13% 1.858
2002 2.753 12% 1.810
2003 3.084 12% 1.763
2004 3.423 11% 1.701
2005 3.800 " 1.642
2006 4.218 " 1.585
2007 4.682 " 1.530
2008 5.197 " 1.477
2009 5.769 " 1.426
2010 6.403 " 1.376
2011 7.108 " 1.328
2012 7.890 " 1.282
2013 8.757 " 1.237
2014 9.721 " 1.113
2015 10.790 " 1.153
2016 11.977 " 1.112
2017 13.294 " 1.074
--------- --------
Sum N/A $26.359 billion
We get $26.359 billion in value as of 2017.
We now need to add a "continuing value" to the model, because Pepsi will not simply stop to exist after 2017 (unless health activists come to rule the world). To calculate a continuing value, we multiply the free cash flow in 2017 by 11% to arrive at $14.756 billion. We now divide this number by the difference between our discount rate and our growth rate (which is 0.15 - 0.11 = 0.04). Divided, we get $368.908 billion in continuing value. We need to discount this massive value by 15% as of year 18. Doing so, we get $29.809 billion in terminal value.
We add this $29.809 billion in terminal value to our $26.359 billion in year 2017 value for a total value of $56.168 billion. We now divide this number by Pepsi's 1.496 billion diluted shares outstanding. Doing so, we arrive at a value per share of $37.54.
So, our model assumes that in order to achieve a 15% average annual return with Pepsi, we should not pay more than $37.54 per share. Today, the stock trades surprisingly close to that price. With a market cap of $62.8 billion, Pepsi trades at $42, or 11.8% above $37.54. (When we ran a similar model on Wrigley, we found that we needed a share price of about $60 for a 15.5% return. The stock is currently around $80.)
Remember that our model assumes that Pepsi will grow free cash flow 11% annually indefinitely, so there is certainly a significant chance for the model to fail us! That said, this model provides a suggestive valuation for Pepsi today, and that's all we were seeking. In conclusion, the model suggests that Pepsi may be a reasonable value proposition to us and -- with dollar cost averaging on our side the next two decades -- this business may be one that we can comfortably begin buying.
We'll continue this discussion next week. It's your turn now: What do you think? Post your thoughts on the Drip Companies discussion board and don't forget to vote, too, if you haven't!
--Jeff Fischer, TMF Jeff on the boards
