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Is Coca-Cola Stock a Buy?

By Will Healy - Updated Apr 29, 2020 at 7:59AM

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The recent drop in the stock price may or may not offer a buying opportunity.

Recent events have reminded investors that not even an iconic name such as Coca-Cola (KO 1.19%) is immune from adverse affects related to the coronavirus. Yes, the company beat revenue and earnings estimates in its most recent report. However, investors still sold off the stock as the events that the company depends on for roughly half of its sales did not take place.

But looking more closely at the numbers, the COVID-19 pandemic may look more like an excuse to sell than a real reason to sell. Even when the company emerges from the pandemic, the company's increasingly burdensome dividend and diminishing growth prospects may have more of an effect on Coca-Cola than any viral outbreak.

Coca-Cola offers generous dividends amid a decline

For those bullish on Coca-Cola stock, some might wonder if recent events may have created a possible buying opportunity. With economic shutdowns brought about by the coronavirus pandemic, Coca-Cola stock fell along with other consumer brands. At the time of this writing, the stock has dropped by almost 25% from its 52-week high.

KO Chart

KO data by YCharts

Despite its status as a consumer staples stock, Coca-Cola has faced a great deal of uncertainty of late. Consumers tend to buy soft drinks when they eat out, see movies, or attend other in-person gatherings. With few of those events taking place, people have fewer reasons to drink Coca-Cola products, thus sparking concern.

Warren Buffett's Berkshire Hathaway continues to believe in the company. Its 400 million shares constitute a 9.3% share of stock outstanding. Buffett purchased these shares for just under $1.3 billion back in 1988. Today, this investment is worth about $18.15 billion. With $1.64 per share in annual dividends, it also earns $656 million in annual payouts, more than 50% Berkshire's initial cost basis.

This payout could also serve new investors well. At the current stock price, the dividend yields around 3.6%. This comes in well above the S&P 500 average of 2.1%. But with a payout ratio climbing to about 87.5% of free cash flow, the dividend claims the overwhelming majority of company profits.

However, investors should remember that the company increased its streak of annual dividend increases to 58 years with January's dividend hike. The company holds a legal right to pay whatever dividend it wants. Still, arguably nothing could do more damage to confidence in Coca-Cola stock than ending the streak in payout hikes. Moreover, such an event would probably cause Coca-Cola stock to fall, as Dividend Aristocrat funds and other income-oriented investors would likely sell.

Man pours dark-colored, fizzy drink from dispenser.

Image source: Getty Images.

Why new investors may want to still stay away

Furthermore, even if Coca-Cola can maintain the streak, it may offer little more than dividend income to new investors. Coca-Cola stock trades at a forward price-to-earnings (P/E) ratio of around 22.6. This is slightly higher than the S&P 500 average P/E ratio of about 20.3.

However, earnings growth significantly lags the S&P 500. For Coca-Cola, analysts forecast that profits will only grow by an average of 1.86% per year for the next five years. The S&P currently sees increases in profits averaging 5.35%.

The problem with Coca-Cola is that it has long been a victim of its success. Since one can find Coca-Cola in over 200 of the world's countries, its signature product has no significant additional growth markets. Thus, it must depend on its ownership of Minute Maid and its other non-cola products to any increase its profits.

However, earnings growth has long remained in the low single-digits. Rivals such as Pepsico are expected to see earnings increases of 5.37% per year over the next five years. At around 22.9, Pepsico's forward P/E is only slightly higher than that of Coca-Cola. Though the dividend yield of about 2.9% comes in slightly lower than Coca-Cola's, the 47-year streak of payout hikes leaves its dividend under the same kind of pressure for annual increases.

Conversely, Keurig Dr Pepper faces no such dividend streak and may offer a more appealing proposition. Analysts predict 11.16% average annual earnings growth for the same five-year period. Moreover, new buyers will only have to pay just over 19 times forward earnings for this rate. These growth prospects will probably persuade some investors to overlook the more modest dividend yield of approximately 2.3%.

Coca-Cola continues to hold its status as a long-standing Dividend Aristocrat. Those who bought Coca-Cola stock in the 20th century, like Warren Buffett, should stay with this company, if only for the dividend. However, this stock leaves new investors with little opportunity and a payout that remains difficult for the company to maintain. Hence, new investors looking for a position in this sector will likely see higher returns in a different beverage company.

Will Healy owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short June 2020 $205 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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