FOOL ON THE HILL
An Investment Opinion

Fun With Coke's P/E Ratio

By Brian Graney (TMF Panic)
November 23, 1999

Everybody's favorite red and white branded global consumer product giant, Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %>, has received a lift this week as sell side analysts have thrown their support behind the company's future growth prospects. And why not? The global economic problems that have depressed Coca-Cola's unit beverage sales over the past several quarters appear to be abating. Meanwhile, the world's citizenry appears to be as thirsty as ever. Sounds like a good bet.

What has been most interesting to see, however, is the analyst community latching onto the company's current valuation, as measured by the ubiquitous price-to-earnings (P/E) ratio, to buttress the bullish thesis. This tack was unheard of just a few years ago, when Coke's P/E ratio was regularly dragged over the coals by value zealots who seemingly believed that anything above an arbitrary multiple, such as 15 times forward earnings, was an outrageous price to pay for any company, world leader or otherwise. Now it seems as though analysts at Merrill Lynch and Lehman Brothers believe that at roughly 40 times next year's expected earnings, Coke may be cheap on a historical and relative basis to the market.

Typically, Fools groan when Wall Street randomly presents us with a firm's P/E ratio, slaps on a premium to what the company should trade to the overall market or its historical precendent, and calls the whole exercise "valuation work." Valuing a company cannot be boiled down into a single magic number, no more than the value of any one individual can be pigeon-holed by a single piece of data such as yearly income or the type of car they drive. But despite numerous diatribes to the contrary by Fools in this forum in the past, single-shot valuation analysis using the P/E ratio actually carries some merit in this case.

The major shortcomings of the P/E ratio -- namely, that it does not take into account a company's risk profile, its capital needs, or the opportunity costs of its internal investment decisions -- still apply to Coke, but arguably to a much lesser extent than most other companies. The moat around Coke's business is wide and deep. It has for years easily beat its cost of capital and earned a healthy amount in operating earnings from every dollar of capital invested in the business. Further, its return on marginal capital is consistently very high. With such a steady state business, the P/E ratio actually does a pretty decent job of acting as a proxy for how the market is discounting Coke's future cash flows back to the present.

Then again, basing an opinion that a stock is a "top pick for 2000" solely on relative and historical P/E measures, as Merrill Lynch did earlier this week, is going overboard and does little to get at the meat of why Coke is such a great business that will generate "top pick" returns for an investor over the next 12 months. The following chart shows what Coke's real value drivers have been in the recent past:

      1988   1989   1990  1991   1992   1993   1994   1995   1996   1997   1998

EPS  $0.37   0.43   0.50  0.60   0.71   0.83   0.98   1.17   1.38   1.64   1.42 
Grw           16%     16    20     18     17     18     19     18     19    -13              
P/E   15.1   22.5   23.3  33.4   29.5   26.9   26.3   31.7   38.1   40.7   47.2
ROC  21.3%   26.5   26.8  27.5   29.4   31.2   32.8   34.9   36.8   39.5   30.2

MC   $15.8   26.0   31.1  53.3   54.7   57.9   65.7   92.9  130.6  164.8  165.2 

What is remarkable about this chart is that it shows how closely Coke's market capitalization (MC) over the past ten years has moved in lockstep with the firm's cash-in, cash-out dynamics, as reflected by the company's own measure of return on capital (ROC). As a consequence, Coke's P/E ratio has expanded. This is an important point, as our little chart shows clearly that the P/E ratio is a function of a company's value, not a determinant of its value. As the intrinsic value of Coke's business increased with ever higher earnings and returns on capital, that value creation ability was reflected in the market by a higher P/E.

The value creation came first; the higher market multiple came second. When Coke hit a speed bump in its international operations last year, resulting in lower earnings and return on capital, the market capitalization growth also stopped dead in its tracks. But importantly, the company's P/E kept rising. Why? Either the apparent link between the firm's P/E ratio and its return on capital over the prior ten years broke down and turned out to be just a coincidence, or the market was trying to tell us something about how highly it values Coke's business economics, even in times of declining profitability.

Only time will tell for sure if the market has been wrong this year, but I'd be willing to bet that Mr. Market is correcting an old valuation inefficiency and not creating a new one. If Coke can get back to its old ways of increasing its return on capital year after year, then the market valuation will again reflect the economic value creation that is taking place and everything will be right with the world again.

An examination of these relationships is glaringly lacking from this week's P/E-related calls on Coca-Cola. As the historical data shows, what is happening to Coke's P/E is pretty much irrelevant to figuring out where its share price will go in the future. Moreover, how Coke is valued on a price-to-earnings basis to the entire market is an even more irrelevant matter.

If Wall Street insists on using historical P/E comparisions in its valuation work, it should a least make an effort to compare those figures to the data that really matters. In this case, comparing the relative level of the P/E to the company's return on capital performance, while possibly a flawed way of looking at things, would add considerably more value to the investment process.

In short, Coke's value creation ability in the years ahead will steer its future share price performance, not its historical or relative P/E levels. That is where investors should be focusing their attention right now, regardless of what the Street is saying.