Coca-Cola (KO) is a very profitable company that delivers a beautiful stream of free cash flow (FCF) year after year. However, the main problem is that these free cash flows have relatively low growth opportunities and the stock is already fairly valued. For starters, check out KO’s historical free cash flow generation in the following chart.
As the chart shows, Coca-Cola (Coke) brings in a large and steady stream of cash from operations every year, and spends only a small amount of those cash flows on capital expenditures. This leaves lots of free cash flow for the company to do things like pay dividends, repurchase shares and invest in growth. Investing in profitable growth opportunities is generally the best option for most companies (because it increases the value of the company). However, Coke only spends a relatively small portion of its cash from operations on growth, and it has historically returned a large percentage of its free cash flows to shareholders in the form dividends and share repurchases. This suggests that Coke doesn’t have the types of big growth opportunities that would result in a significant increase in the value of the company. Also, according to the 26 analysts surveyed by Yahoo Finance, Coke’s earnings are only expected to grow at 2.8% per year for the next five years, well below the industry average of 11.9% and the overall market (S&P 500) at 5.7%.
Based on Coke’s free cash flows, cost of capital and expected growth rate the company is fairly valued. For example, based on year-to-date data through the third quarter of 2015, we are forecasting Coke’s annual free cash flow to be around $8.7 billion. Using this $8.7 billion, assuming a 7.5% weighted average cost of capital, and a 2.8% growth rate, Coke is worth $184.7 billion. There are approximately 4.35 billion shares outstanding giving Coke a value of $42.47 per share. This value is very close to Coke’s current market price giving the stock very little upside return potential.
Another way to think about Coke’s value is simply it’s free cash flow yield. Dividing our $8.7 billion expected 2015 FCF by the shares outstanding gives us about $2 of free cash flow per share. And with the share price around $42, our free cash flow yield is approximately 4.8%. That means for each share of Coke you buy, the company has the ability to return $2 to you via dividends and share repurchases. In reality, the company will spend a little bit of that free cash flow on growth opportunities, and this is how we arrive at our $42.47 per share valuation from above. In a nutshell, if you buy Coke you’ll safely receive the 3.2% annual dividend yield, plus 2.8% growth (keep in mind the 2.8% growth will vary from year to year due to market conditions such as the headwinds the company currently faces due to the strong US dollar).
Coke’s total return potential is not a bad, especially considering it’s very safe relative to other stocks. However it is still a lower return than we expect on the overall market. And if you are a long-term investor, you will miss out on enormous long-term return opportunities because Coke’s subpar total return will be greatly magnified over the years as it misses out on the compound growth opportunities offered by the rest of the market. For example, something as simple as an S&P 500 index fund will provide better long term returns than Coke.
Why Does Warren Buffett Own Coca-Cola?
Many investors believe if the great Warren Buffett owns Coca-Cola stock then it must be a good investment for everyone else. Not true. The reason Warren Buffett’s Berkshire Hathaway owns Coca-Cola stock is because it provides a safe steady return that can be magnified with leverage. This paper, “Buffett’s Alpha,” received notoriety a few years back as it essentially decomposed Buffett’s truly amazing long-term track record of outperformance. One of the biggest drivers of the outperformance is the use of leverage. The paper finds that Berkshire Hathaway magnifies its returns by leveraging its investments by around 1.6 times. Essentially, Berkshire Hathaway owns Coke on its balance sheet, and then uses its strong balance sheet to borrow money and then buy more investments. For every $1 Berkshire Hathaway has, they’ve been able to purchase $1.6 worth of investments. This basically means, through the use of leverage, Buffett can buy Coke for around $26 per share whereas the typical investor doesn’t use leverage and has to pay around $42 per share.
The paper finds there are a variety of other factors that have contributed to Buffett’s long-term performance (skill is one of them), but levering up on low-return companies with disproportionately low levels of risk (such as Coke) has been a big contributor to Buffett’s success. Unless you are borrowing money to purchase shares, your long-term return on Coke will probably be far less than the return achieved by Berkshire Hathaway.
Should Dividend Investors Own Coca-Cola?
If you’re in the rare position where you truly need the dividend payment to help cover your ordinary living expenses then it’s smart to own Coke for its reduced short-term “uncertainty risk.” This seems to run contrary to the strong belief among many professional investors and academics that claim investors should be indifferent between dividend payments and capital appreciation. In fact, Nobel Prize winners Franco Modigliani and Merton Miller are famous for proving exactly this point (i.e. investors should be indifferent between dividends and capital appreciation).
However, if you are a retiree that relies on dividend payments to meet your ordinary living expenses then you may not be able to handle extreme short-term market volatility such as what happened during the 2008-2009 financial crisis. If you need cash to help pay the bills for the next 30 years of your retirement then you probably couldn’t afford to sell stocks at fire sale prices to raise cash such as during the depths of the financial crisis because you would have missed out on the tremendous capital appreciation rebound that occurred over the following five years. However, if you were invested in dividend stocks, you would have received your exact same dividend payment throughout the crisis (companies rarely cut the dividend) and you would not have been forced to sell anything at a fire sale price. The dividend provides a little piece of mind and helps your money last throughout retirement. In fact, there is a great academic paper out there about volatility that explains what smart investors have intuitively known for years: Stock market returns are very hard to predict, but “dividend yield exhibits the strongest relation to expected return.” (Pastor and Stambaugh, p.14).
The problem with dividend investment strategies is that they are totally unnecessary for most investors. They generally result in less diversified portfolios with much lower long-term total returns. For example, dividend portfolios are often concentrated in certain sectors and styles such as utility companies, real estate investment trusts, master limited partnerships, and low-beta/ low-return companies like Coca-Cola. In the case of companies like Coca-Cola, even if investors achieve total returns only 1% lower than the overall market (e.g. an S&P 500 index fund) this shortfall dramatically compounds over time. For example, over a twenty-five year period the difference between investing $100,000 in a stock with a 7% annual total return versus one with an 8% annual total return is $542,743 versus $684,848. Given the choice, why not put the extra $142,104 in your pocket? Said differently, if you are a long-term investor, and your name is not Warren Buffett, then don’t buy Coke.
Coca-Cola is a terrible stock to own for most investors. Even though it may offer lower uncertainty, it also offers lower expected returns. Owning Coke will dramatically reduce the size of your nest egg relative to other better investment opportunities. For example, the Blue Harbinger 15 is a list of specific stocks that we believe will provide much better long-term returns. And if owning individual stocks in not your thing, then just buy an S&P 500 index fund. For example, ticker SPY is a low-cost S&P 500 Index fund that we believe will provide a far better long-term return than Coca-Cola.