Valuation of Coca-Cola and PepsiCo - Research Paper Example

of the of Topic: Valuation of Coca Cola and PepsiCo Introduction This seeks to conduct financial analysis and valuation for Coca Cola (CC) and PepsiCo on the basis of available information including those from their annual reports for the past five years. Financial analysis will look at profitability, efficiency, liquidity and leverage position of the companies. Valuation models including DCF and EVA will made applied using company’s financial information and some market ratios. 1.1 Company Profiles Coca-Cola Corporation (or “CC”) is one the leading brands of the world that offers non-alcoholic beverages. The company is an American based multinational enterprise having headquartered in Atlanta. Coca-Cola Corporation has introduced more than 500 brands and some of the renowned brands are Coke, Diet Coke, Caffeine Free Coca-Cola and Coca-Cola Zero. The company has its presence in more than 200 countries of the world and is more renowned as Coke. More than 1.7 billion people are served every day with the products of Coca-Cola.1 PepsiCo, Inc. (or “PEP)” is another American based multinational enterprise that operates in the food and beverage industry. Headquarter of PEP is in Purchase, New York. The company was formed in 1965 and since that time it has expanded its brands to more than 200 countries. PEP is the fifth largest food and beverage company in the world in terms of total revenue however in the North American region it is the largest company. There are more than 285 thousand employees working for PepsiCo around the world.2 1.2 Industry View Food and beverage industry includes food production, distribution, retailing and catering of food and beverages. The total value of this industry in the year 2008 was $5.7 trillion. The growth rate of the industry is expected to increase at a CAGR of 3.5% and it is estimated that the total value of this industry would reach up to $7 trillion by the end of 2014.3 As other industry suffered because of financial crisis, food and beverage industry was also one of the victims of recession. The industry was affected and companies in the industry had to face different problems like increase in food prices, increase in transportation cost and a reduction in consumer spending thus, reducing the profitability of the companies in the industry. PepsiCo is the fifth most important company in this industry with offering different products like snacks, carbonated and non-carbonated drinks. The total revenue of PepsiCo is $43.3 billion USD with a net profit of $5.1 billion. Coca-Cola Corporation is considered to be the seventh most important company in the industry with total revenue of $31.9 billion and net income of $5.8 billion. The industry is led by Nestle with total revenue of $101.8 billion which has grown by 13.5% in 2010 from 2009. The net profit of Nestle in 2010 was $16.7 billion.4 The industry future looks bright as the economy is currently recovering from recession and many companies are planning to expand their businesses and acquire firms in the industry. 2. Financial Analysis Financial analysis makes used of financial ratios on profitability, efficiency, liquidity and financial leverage. 2.1 Profitability and Efficiency Coca-Cola’s profitability appears similar with PepsiCo. Based on average return on assets for the fast five years, both exhibited 15%. However, the same behaviour is not observed in terms of net operating margin where Coca-Cola had 23% as against 13% for PepsiCo. Both their net profit margins are lower than the operating margins for both companies which indicate that their profitability were not complemented with non-operating item. This would also mean that these companies are net borrowers or were leveraging on the use of their debts. As profitability is a function of revenues and expenses, they are paying interest expenses but were benefitting the shareholders. Table A– Comparative profitability and efficiency ratios5 It may be observed that Coca-Cola had a higher net operating margin than that of PepsiCo as expressed in the ratios. It is not the apparently the same when viewed in terms of absolute pound or dollars as Coca-Cola s financial statements are presented in terms of UK pounds while that of Pepsico was presented in terms of US dollars. Therefore, from the point of view of any analyst, the ratios would be better measures of profitability since the data are standardized or converted into rates. Thus one with the higher rates would be more profitable. Coca-Cola therefore may be declared more profitable still than Pepsico in relation to getting most from revenues both in relation to getting most from assets they are same. See Table A. The seeming similar or better profitability of the CC against PEP is not further observed in terms of Return of Equity (ROE) where Coca-Cola showed 30% average for the past years, which is lower this time than that of Pepsico which reflected an average of 35% for the same past periods. This seems to show conflict with similar Returns of Assets (ROA) where both companies exhibited a five year average of 15%. The lower efficiency of PepsiCo in term of net profit margin and operation margin but got equalized in ROA are overshadowed by higher profitability of Pepsico on terms of ROE. See Table A above. While ROA measures how efficient management of a company in terms of assets employed in business, ROE measures how stockholders are rewarded by management from the former’s investments in stocks.6 By comparing the two ratios, it would seem that the management of Coca-Cola has shown leverage in using companys’ assets that since Coca-Cola’s ROE’s is higher than its ROA. The same observation is evident from that of PepsiCo. Stockholders of both companies became wealthier assuming all other things are equal for the past five years. The profitability of CC and PepsiCo can be further confirmed when compared with the rest of the retail industry. The ratios indicate that while the rest of the firms in the industry were experiencing moderate profitability/efficiency industry ROA of 7% and industry ROE of 13%. Coca-Cola is clearly doubling the rate just in the industry but PepsiCo shows the same in terms of ROA. But in pleasing the shareholders, PEP appears to be more valuable with higher ROE against CC and the rest of the industry. See Table A 2.2 Liquidity Business entities need to be liquid in order to meet their maturing obligations in the short-term. Liquidity in banks could be measured by the liquidity ratios particularly current ratio and quick asset ratio. Being profitable with a given capital structure also involves also short-term strength or capacity and this is known as liquidity.7 This subsection would therefore discuss on what drives companies to survive at least in the short-run and how these company managed their working capital as needed in operations.8 In case of failure in liquidity, every company faces the risks of bankruptcy or control of the business by creditors.9 Companies which cannot meet their currently maturing obligations would not be able have its officer employees doing their next day or period. Unpaid officers and employees would mean unmanned office. In addition, would mean no one to meet or deal with suppliers. One may make an inference that the company be blacklisted or sued the company for failing to honour its commitments to legally and ethically deliver goods to customers. As soon as bankruptcy sets, closing shop or giving in control of the business to said creditors would be come next. The next day may indicate creditors becoming in control of the business. Coca-Colas average current ratio for the past five years registered at 1.06 which is quite lower than PepsiCo average of 1.28 for the past five years. Both of them have lower liquidity than industry average of 1.65. With CC’s exhibiting a lower liquidity, the same may be expected because of the lower profitability of the same compared with PepsiCo. Although industry comparison in terms of profitability earlier was made earlier involving the two companies company, better liquidity need not follow better profitability since there is an alternative use of funds from operations other than liquidity. The alternative is to improve the long-term view or the capital structure. On the other hand, a slightly lower liquidity may be an evidence of its better profitability and efficiency as funds were used productively rather than rather kept idle. See Table B below. Table B- Comparative Liquidity and Leverage ratios The Companys quick assets ratio may also further measure the company’s liquidity. As differentiated from current ratio, its quick ratio should be a stricter measure of liquidity and normally it is lower than the first. This is because stock or inventory and prepaid expenses are out from the current assets before dividing the net amount to current liability. Only therefore cash, receivable and marketable securities or short-term investments could be considered as quick assets to match the companys current liabilities. CCH has also lower quick ratio at an average of 0.72 than the industry at 0.89, yet the company has not been bankrupt.10 The difference may be explained by the better profitability of PepsiCo over CC. 2.3 Financial Leverage Finance language defines solvency or leverage like liquidity which has also something to do with the ability of an enterprise to pay its debts with available funds like cash which is presumed to exist. But this time, solvency must be long-term or it needs to refer to financial stability of the company to survive. If it was successful to meeting short term problems, this time it must have sufficient investment from stockholders to match long term debt of the company together with currently maturing obligation. Leverage also differs from the concept of profitability, as the former refers to the ability of a company to earn a profit so businesses may show a profitable result of its operation without being solvent as in the case where these corporations are on the stage of increasing rapidly in the early part of business. On the other hand business entities can be solvent even while not being profitable like when the sacrifice supposed to be good future cash flows. These may occur when they sold receivables or collectibles as a big discount. Ideally a company must be moneymaking as shown by its profit, liquid and solvent or with adequate capital. However, to keep these three things in balance is the work of a well-functioning management as it tries to maximize value of the business. It can thus be deduced that a business can get bankrupt when it is losing money due to unprofitability and could eventually become insolvent. Applying the knowledge in the case of the companies, average debt to equity ratio for Coca-Cola is 1.01 for the past five years while PepsiCo has reflected 1.5 averages for the same periods. Please refer to Table B above. Coca-Cola may be declared to have better financial leverages because it has the lower average or lower risk level it meets it challenges in the future. If likened to a car battery, it Coca-Cola’s sustaining power is stronger and has more stable life than that of PepsiCo. This would also validate the possibility that CC may be focusing more on solvency for financial rather than liquidity compared with PepsiCo. 3. Valuation 3.1 Cost of Capital Information about their cost of capital is needed for discounting purposes and for purposes of applying before a valuation of the stocks of Coca-Cola and PepsiCo could be made using some of the models used in this paper. An estimate of the cost of capital11 can start with cost of equity and cost of debt could be added if the company is financed by both equity and debt. The said cost of capital represents the opportunity cost concept in economics as it assumes that for every choice made, there is an alternative forgone.12 In simple terms, there is an alternative to putting money in stocks of the either CC or PP which may involve risk of not being able to realize predicted values. Generally, a person or any investor can just put his or her money to the bank like certificates of deposit or treasury bills or bonds and type of investment assumes a risk-free type of investment. By doing nothing or just sitting down, one can wait an expected return on investment without worrying that the manager will mismanage the business. This risk-free investment is also relevant to computing the cost of capital under the CAPM model.13 It may therefore be used as well in discounting cash flows for CC where the formula is: Required (or expected) Return = RF Rate + (Beta * (Market Return - RF Rate)). The variable RF stands for risk free rate and the rest of the formula is the market risk premium, which is used to compensate the investor for the additional risk involved as investments are place in risky ones. If applied with Coca-Cola, the formula would show that the company would have an estimated cost capital of 7.47% as computed as follows: Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) = 0.25% + 1.52 (5%-.25%) = 7.47%. Using the same formula, the cost of capital for PepsiCo would be 2.72%, computed as follows: Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) = 0.25% + 0.52(5%-.25%) = 2.72%. Note that the risk-free rate for both companies came from Bank US base rate.14 Estimating the cost of capital is also possible by getting the reciprocal of the industry price- earnings ratio or P/E. Said P/E ratio is normally calculated by dividing the market value per share of stock by the earning per share of the company. The said ratio signifies the willingness or unwillingness of investors to buy a share of stock for every level of earnings per share in companies (Brigham and Houston, 2002). Using the reciprocal of industry P/E low ratio for last five years would produce an estimated cost of capital of 5%, which is computed by dividing 1 by industry P/E ratio of 19.3815 (Reuter 2011c). Note the same rate was equivalent to market rate used in CAPM above. Thus to compare the two, it would be more scientific to use the CAPM estimate for the purpose of this paper. 3.2 Valuation Proper Valuation measures the success of a company in actually delivering value to its shareholders in terms of wealth maximization objective. This paper applies the Discounted Cash Flow Method. 3.2.1 The Discounted Cash Flow (DCF) Model The free cash model works with the principle of projecting cash flows. The latter could be derived from the activities of a company bringing them to their present values by discounting them. It has likeness with the dividend discount model16 where dividends are discounted. Instead of stream of dividends being discounted, the stream of cash flows or benefits. The computed cost of capital at 7.47% for CC and 2.72% for Pepsi as computed earlier would be used to bring future values to their values at present. This discount rate explains the time value of money concept where US$1000 today should have more value than US$1000 in the future. The discounting considers the possible gains and losses in value arising from inflation and other economic realities. To prepare the equity value under the DCF method requires estimate for the future years and therefore. A projected income statement was prepared for the next ten years to be able to support the growth of the company in relation to what the economy and its resources allow.17 Annual revenues were conservatively assume to grow first by 10% for the coming years for both companies with the assumption that within range that the economy will allow. After the getting the revenue increases, it was necessary to forecast also the operating costs. The operating costs consist of the cost of materials and supplies, used, the payment for its employees’ salary, the costs of maintaining and repairing assets, including those used in marketing and administration. Average of the cost items for the past five years was used for purposes of estimating the behaviour of these costs in relation to the projected sales revenues. It was determined however to be within the range of 70% to 75% of total revenue for CC and about 75% to 80% for PEP. Particularly interesting in the preparation of the projected earnings is the depreciation and amortization which are supposed to have also direct association with total assets and revenues of the companies. The same was therefore estimated and this paper had used the average ratio of these costs to sales within the range of below 0 to .01% for CC and 0 % to 0.25% for PEP. Notice that depreciation and amortization do not involve cash flow and they are only deducted for purposes of computing the payment for taxes also in the future. Changes in working capital were also assumed based on past experience. The combined effects of these cost items for both companies would be as shown in Appendix C. 2.3.2.2 Economic Value Added The economic value added (EVA) concept assumes that a proposal or an option is creating value when operating income exceeds the cost of capital employed. The method can be viewed as refinement of the earnings idea by getting the residual income that may come from the true economic profit of an organization after deducting the cost of capital for the assets as invested in the business. Applying this method to CC and Pepsico hand, their net operating income after tax (NOPAT) are taken from the financial statements to be reduced by the capital cost. NOPAT is the same as net income after tax of the companies. The capital cost is computed by multiplying invested capital by the cost of capital of for each company as earlier used under the CAPM. CC’s resulting EVA is $9.4 billion and if this is divided by the outstanding 2,292 million shares, the value per share would be reflected at $4.14. Compared with present share price of the company at NYSE of $ 64.8718 the company value in the stock market may indicate overvaluation. The result would assume that the financial performance of the company, if incapable of generating profits in excess of the cost of capital, will have a favourable effect for the share price of CC. PepsiCo’s resulting EVA is $5.7 billion, divided by the outstanding 1,581million shares, with value per share would be reflected at $3.63. Compared with present PEP’s share price of the company at NYSE of $62.419 the company value in the stock market may also indicate overvaluation. 4. Conclusion This paper has found PepsiCo to be more profitable, similarly efficient, and more liquid but more financially leveraged than Coca Cola. As far as their valuation is concerned, PEP stock was found undervalued while that of CCH was found overvalued stock. For investment purposes, it would be better to invest with PepsiCo and holders of CC stocks should better sell their stocks before prices will fall because of the overvaluation based on DCF valuation method. The result of the DCF should prevail over the result of EVA as the latter has more limitations than the first. Although both are profitable, if one has to choose which stocks to buy, PepsiCo is recommended. 5. Appendices Appendices A – Summary of Financial Data and Ratios for CC20 Appendix B - Summary of Financial Data and Ratios for PEP; Sources21 . Appendix C – Valuation -DCF22 Appendix D.23 Work Cited “Annual Report for 2006”. 2011. Pepsico. 16 Nov. 2011 “Annual Report for 2007”. 2011. 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Reuters. 20 November 2011 < http://www.reuters.com/finance/stocks/companyProfile?symbol=PEP.N> “Industry Ratios” . 2011. Reuters 20 November 2011 < http://www.reuters.com/finance/stocks/financialHighlights?symbol=CCH.N> Helfert, E. Techniques for Financial Analysis. Sydney: IRWIN, 2001 IMAP. Food and Beverage Industry Global Report. 2010. 15 Nov. 2011. http://www.imap.com/imap/media/resources/IMAP_Food__Beverage_Report_WEB_AD6498A02CAF4.pdf “US Base Rate” 2011. Housepricecrash. 16 Nov. 2011 Read More