Monday, December 08, 1997
The Daily Workshop
Report
by Robert Sheard
(TMF Sheard)
LEXINGTON, KY. (Dec. 8, 1997) -- One thing we don't do often in the workshop is talk about valuation techniques applicable to individual stocks. It's one of the primary Foolish tenets, of course, that investors should be able to do some basic financial analysis, so in that spirit, I'll be devoting some of my columns through the end of the year to analyzing a handful of individual stocks, not based on the screens we follow mechanically in the workshop, but with valuation tools gleaned from the best value investor of our time, Warren Buffett.
Today, I'll start with a classic Buffett holding just to remain consistent, Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %>. By way of disclaimers, I hold a position in Coke and have since April.
Consumer Monopolies and Predictable Earnings
The first test for Buffett is to determine what kind of stock he's looking at. He's typically not at all interested in cyclicals for his long-term holdings (read a decade or more) because their earnings are not predictable. And if the company constantly has to retool its plants, what earnings it does generate are sucked up in plant refurbishing, not reinvested in ways to expand shareholder value. (Do the automakers come to mind here? They should.)
So Buffett looks for what he calls Consumer Monopolies with long-term earnings that are strong and consistent. They're companies that don't need to retool every few years, dominate their industries, invest their capital well, and (perhaps surprisingly) don't pay out a high percentage of their earnings in dividends. (Dividends are taxed as ordinary income to the shareholders even after the earnings have been taxed as income to the company, not the most efficient way to create shareholder value.)
So, let's see if Coke qualifies on the earnings front (as there's no doubt about Coke's being a consumer monopoly). Since 1987, here are the annual earnings per share totals for Coke:
1987 0.30
1988 0.36
1989 0.42
1990 0.51
1991 0.61
1992 0.72
1993 0.84
1994 0.99
1995 1.19
1996 1.40
1997 1.69 (three quarters reported plus
the Value Line estimate for Q4)
Earnings have grown every year in the last decade, so consistency isn't an issue. The earnings growth rate from 1987 through 1997 has been 18.9%. For the last five years it's been 18.6%. So the strength of earnings growth isn't an issue either. In other words, this is a perfect company to explore further, but is it worth your money at today's price?
Initial Return on Investment
A simple test Buffett runs is to value the stock relative to what he could get in a long-term government bond. Today the 30-year bond yield is 6.1%. If you take the past twelve months' earnings for Coke ($1.65 a share through Q3) and divide it by today's price for Coke (approximately $63.50), you get an Initial Rate of Return of 2.6%. In other words, Buffett looks at this as if he were buying a Coke bond with a coupon interest rate of 2.6%. Now compared to the 6.1% available on the long bond, 2.6% doesn't look very attractive, but there's something else to consider. The earnings have been growing at nearly 19% a year. So while your initial return is only 2.6% a year, it's a coupon that's growing each year by 18% or 19% while that government bond is going to remain constant at 6.1%. The yield on the Coke "bond" would catch up to the government bond yield in roughly five years as a result of the earnings growth and then continue expanding as long as Coke's earnings continue to rise at their historical rate.
Earnings Growth Rate Projections
That's one way to analyze the stock. Let's look at another. If Coke earns $1.69 per share in 1997 and its long-term earnings growth rate is 18.9%, projecting that growth over the next decade would give us earnings in the year 2007 of $9.54 per share. Over that same time, Coke has been paying out approximately 38% of its earnings in the form of a cash dividend and retaining the rest. The dividend in 2007, then, would be $3.63. The total in dividend payouts over the ten years, using an 18.9% in annual earnings growth and a 38% dividend payout rate would equal $18.77.
If we apply the historical range of Price/Earnings multiples for Coca-Cola over the last ten-year span, we get a range from 14 in 1988 to today's level around 40. At a P/E of 14, Coke's projected earnings of $9.54 in 2007 would give us a share price of $133.56. Using the highest multiple of 40, the share price would be $381.60. Neither P/E extreme is a safe bet, so let's also use the ten-year average P/E of 23. The price in 2007 at that level would be $219.42.
With a price today of $63.50, then, here's the range of returns (on a pre-tax basis) that we can expect for holding Coke for the next decade with the assumptions that its earnings will continue to grow as they have over the last decade and its dividend payout ratio remains the same. After adding in the dividend stream produced, the profit per share using a 14 multiple would be $88.83 ($133.56 + $18.77 - $63.50), for an annualized pre-tax profit of only 9.14%. At the high end of the historical P/E range, the profit per share would be $336.87 ($381.60 + $18.77 - $63.50), for an annualized pretax profit of 20.22%. At an average P/E of 23, the profit per share would be $174.69 ($219.42 + $18.77 - $63.50), for an annualized pre-tax gain of 14.13%.
So there's a range of expected returns from 9.15% through an average 14.13% to a high-end of 20.22%.
Return on Equity
Let's look at a third way to value Coke's earnings. Buffett isn't too interested in what a company is going to be earning this quarter or next, but what it will be earning in a decade or so. And short-term analyst forecasts like the ones we saw hit the news (and the stock price) today are virtually immaterial to him. Remember, Coke is a consumer monopoly with steady earnings, so Buffett believes we can predict with a fair amount of certainty its future earnings stream.
Another favorite technique Buffett uses is based on the company's return on equity. The shareholders' equity is simply what's left over after you subtract the total liabilities from the total assets. Just as with your house, after you subtract the mortgage balance from the value of the house, the remainder is your equity. To find the equity per share, then, divide the shareholders' equity by the number of outstanding shares of common stock. Using Value Line's projections for 1997 (after three quarters have been recorded), Coke has some 2.445 billion shares of stock outstanding and the shareholders' equity is equal to $7.550 billion. The equity per share, then, is $3.09.
That's our starting point. For the last five years, Coke's return on shareholders' equity has averaged 52% a year -- a phenomenal rate considering the average for most companies has been around 12%. In fact, it has grown steadily from the high 20% range in the mid-1970s to its current level well above 50% a year for the last three years. To be a tad conservative, though, it's best to stay somewhat in the middle, so we'll use the five-year average of 52%.
Based on that $3.09 per share equity value and the 52% return on equity, Coke should earn $1.61 per share in 1998, of which 38% will be paid out in dividends ($0.61), and the rest ($1.00) will be retained earnings, adding to shareholders' equity and reinvested for them by the company, either in expansion of the business or used for stock repurchases (a strategy Coke has been using actively).
Here's a chart to show how this progression of earnings, dividends, and retained earnings would look like under this scenario for the next decade.
Year Equity EPS Div. Retained 1998 3.09 1.61 0.61 1.00 1999 4.09 2.12 0.81 1.32 2000 5.40 2.81 1.07 1.74 2001 7.15 3.72 1.41 2.30 2002 9.45 4.91 1.87 3.05 2003 12.50 6.50 2.47 4.03 2004 16.52 8.59 3.27 5.33 2005 21.85 11.36 4.32 7.05 2006 28.90 15.03 5.71 9.32 2007 38.21 19.87 7.55 12.32
As you can see by comparing the EPS number for 2007 in the two models, this method values Coke much higher after a decade, in part because of Coke's management's ability to employ retained earnings in such a terrific manner over the years. Based on the same historical range of P/E multiples we used in the earnings growth model, let's put a price tag on Coke for 2007.
At 14 times 2007 earnings of $19.87, Coke's price would be $278.18. Add in the dividend stream ($29.08) and the final value is $307.26 a share. We'd pay $63.50 now, so that would give us a pre-tax annualized return of 17.08%.
The average P/E of 23 gives us a price of $457.01 plus the dividends, for an annualized gain of 22.57%. And the astronomical 40 P/E multiple Coke carries today would give us a price of $794.80 plus the dividends, generating an annualized pre-tax return of 29.21%.
Putting It All Together
Between our two models we have expected gains of anywhere from 9% to 29% a year for the next decade. Personally, I'd use the middle-range projections based on the average annual P/E of 23 over the past decade. That would give us an estimated pre-tax profit range of 14% to 23% a year.
I think, however, this may even be somewhat conservative for two very important reasons. As we've already seen, Coke's management has been able to achieve superior returns on equity, improving the return nearly every year for some two decades. In addition, the company has also been consistently reducing the percentage of earnings it pays out in dividends, which means it's retaining more earnings that can be invested by Coke's management without additional tax burdens to the shareholder. That combination and the aggressive share repurchase programs have helped Coke become one of the most powerful stocks over the past decade, earning its shareholders an annualized return of more than 32% since 1987. (Doesn't make the Return on Equity forecast look so outlandish now, does it?)
One final note: Coke's stock repurchase program will throw off the equity value per share from estimates using this approach, but that won't hurt the stock's performance. Reducing the number of shares increases each shareholder's piece of the pie in a tax-effective way. So while the equity per share numbers might end up considerably lower than this projection after a decade, the earnings per share figures aren't likely to suffer from such an action by the management. Fool on!
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