In this article, I will be focusing solely on the financial figures and dismiss the qualitative evaluation since there are already a host of other great articles filling this void.
Buy and hold type of investing works best when it is done in a marvelous business which is able to grow in shareholder-friendly manner over business cycles while still keeping margins intact. As we all now, it does not matter how wonderful a business is, it still does not make economical sense to buy the company at any price offered by the market. Of course, in the long term, since a prodigious business increases shareholder value year after year, it does not matter whether you slightly overpaid for the shares. Therefore, initial investment in great business is much more forgiving – providing the security stays great. This is, however, not the case with average or below average securities where you have to strictly follow the old adage of “buy low and sell high.”
In my opinion, there are only 2 ways which determine the profitability of your investments. First of them is buying as cheaply as possible. Second is investing in a profitably growing wonderful company with strong moats which makes it much more likely to receive ever-increasing stream of dividends in the future. Investing this way puts the odds in your favor. In this article, I will try to analyze whether or not The Coca-Cola Co (NYSE:KO) is able to fill both of the criteria mentioned previously and what kind of return you could expect by purchasing the stock now from the market. In this analysis, I will be relying solely on PerShareData.com.
Let’s first check whether Coca-Cola is able to meet the financial criteria of a wonderful business. There are no global standards for this, so I will be using my own in determining these. In order for a company to meet my standards of being a great business, it has to meet the following requirements:
- Revenue growth over business cycles
- High margins
- Strong cash flow generation
Why the above criteria? Because average or below average companies are not able to meet the above ones over business cycles. They might be able to meet or exceed them during strong economic upturn but not anymore during the next one. There are of course other crucially important factors as well, such as shareholder friendly management, being a dividend aristocrat, and a strong share price performance. But I personally focus on these after the company has met my previous quantitative requirements.
Revenue growth over business cycles
During the last 5 years, revenue has grown 4.75% annually which has slightly stalled from the 10-year growth rate of 6.72%. Still, nevertheless, the revenue growth has been quite stellar in Coca-Cola’s case when taking into consideration that majority of the businesses in the US have struggled with top line growth after the financial crisis. However, top line growth can be achieved via organically or via acquisitions. As you can see from the net sales per share graph below, majority of the top line growth during the last 8 years came during 2010 when the company purchased the remaining stake in North American operations of its bottling and distribution affiliate. If it wasn’t for that acquisition, top line has pretty much stayed the same since 2008 reflecting the fact that organic growth has been close to zero for a long time.
Personally, I don’t care how top line grows as long as the growth is profitable. How have the margins then evolved lately and during the last 30 years? Return on sales has hovered around 17.5% level for over a decade now implying that Coca-Cola indeed enjoys a strong economic moat. The 17.5% value means that from each generated dollar, the company is able to retain 17.5c to itself which is amazing. Not too many companies are able to do that in the world.
However, if we look at historical return on assets, the 2010 acquisition tells quite a dismal story. Before the acquisition, the return on assets hovered around 15%, which is exceptional. After 2010, the number has been slightly dropping all the way to around 8% level. This clearly implies that the price Coca-Cola paid to acquire its bottling franchise was quite a hefty one leaving the balance sheet boasted with goodwill which is never good from shareholder value point of view. The growth of the goodwill can be seen from the balance sheet when comparing 2009 figures to 2011. Therefore, from balance sheet point of view, we can determine that the acquired growth has not been very profitable.
Return on equity still seems to be following the same path as return on sales and has been around 27% since millennium, and the 2010 acquisition is pretty much invisible in the light of these numbers. All in all, I can quite comfortably say that Coca-Cola enjoys exceptionally strong margins and high profitability which not too many other companies are able to achieve.
Strong cash flow generation
I have always enjoyed investing in companies with low capex needs and stable yet high operating cash flow as it means more money to be distributed to shareholders via share repurchases, debt payment or dividends. By looking at the cash flow statement, we can see that capex has been only around a quarter from operating cash flow implying that the capex requirements are relatively low in Coca-Cola. The situation has not changed much from a decade or 3 decades ago. In addition, the ratio of free cash flow to sales and assets seems to have been always exceptionally high. All of this is very promising from predictability point of view since if a company has been historically able to keep margins and top line growth stable, then it is much more easier for an investor to assess future returns.
Valuation and estimated future returns
By looking at the historical financial figures above, and considering the fact that the company is as well a dividend aristocrat, I would quite comfortably say that Coca-Cola meets all my previous financial requirements of a wonderful business. The chances are very high that even after next economic downturn, Coca-Cola will emerge as an even bigger and more profitable company than today. Now that we have concluded that Coca-Cola can indeed grow shareholder value (at least in history) but most likely in the future as well, we need to next conclude whether the current share price is attractive from an investing point of view. Looking at the historical P/E, P/S, P/B and P/FCF graphs below helps tremendously. Historically, for the last 10 years, P/E has been slightly below 21, P/B slightly below 6, P/S slightly above 4, P/FCF around 23 and dividend yield around 2.6%. Comparing the current valuations (P/E 25.8, P/B 7.4, P/S 4.3 and dividend yield 3%) to historical ones, we can deduce that the current share price of $43 is slightly overvalued by around 15%.
If we assume that Coca-Cola is able to sustain the 4.75% top line growth (most likely mainly via acquisitions) for the next 5 years and keep the current margins intact, then we could assume that the historical share price valuation would stay roughly the same as historically. Of course, there are a number of other factors affecting the valuation, such as risk-free rate, market euphoria and expectations to name a few, but since these are impossible to forecast, I feel it is much more easier to estimate share price appreciation potential through historical figures, especially if they have been very stable as is the case with Coca-Cola.
Combining all the above numbers together with the historical share repurchase rate, at the current share price, Coca-Cola could offer investors a solid 3% annual growth via price appreciation and a second 3% growth via dividends leaving the total return around 6.5% for the next 5 years if taxes are excluded. Not sure about the rest of the market, but at least for me, 6.5% is way too low leaving my risk profile unsatisfied. There are other wonderful businesses out there which offer much better investment thesis than Coca-Cola at the moment.