M5.
2 Analysts’ Forecasts and Valuation: PepsiCo and Coca-Cola I
This case is a straight-forward application of the valuation techniques in this chapter. A parallel
valuation of the two firms is in Minicase 6.1 in the next chapter. Minicase 4.1 in Chapter 4 deals
with valuation issues for Coca Cola using discounted cash flow (DCF) analysis, so is a point of
departure for this case. These two firms provide a good comparison, not only because their
operations are similar but because they traded at the same per-share price at the time. They also
have a very similar book value per share and thus similar P/B ratios.
Valuation begins with setting up the pro forma that incorporates the analysts’ forecasts and
converts them into residual earnings forecasts:
The Pro Formas
PepsiCo (PEP): Price = $67; P/B = 4.98; Required return = 9%
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2010A 2011E 2012E
Earnings 4.48 4.87
Dividends 1.92
Book value 13.455 16.015
ROCE 33.30% A
Residual earnings (9%) 3.269 3.429
Growth rate in RE 4.89% A
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Coca-Cola (KO): Price = $67; P/B = 4.95; Required return = 9%
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2010A 2011E 2012E
Earnings 3.87 4.20
Dividends 1.88
Book value 13.527 15.517
ROCE 28.61% A
Residual earnings (9%) 2.653 2.803
Growth rate in RE 5.67% A
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The Questions
A. The ROCE and RE growth rates are indicated in the pro forma for each firm
B. The valuation model is:
RE 2011 RE 2012
Value of equity 2010 Book value2010
1.09 1.09 (1.09 g )
where g is one plus the growth rate for the long-term.
PepsiCo:
3.269 3.429
Value of equity 2010 13.455
1.09 1.09 (1.09 1.0489)
= $93.00
Coca-Cola:
2.653 2.803
Value of equity 2010 13.527
1.09 1.09 (1.09 1.0567)
= $93.18
The firms have almost the same valuation! While KO has a lower forecasted forward ROCE than
PEP, analysts are giving it a higher growth rate. However, the $93 valuation is well above the
market price. We must be skeptical of analysts’ forecasts―they are often optimistic. The two
growth rates, 4.89% and 5.67%, are higher than the typical GDP growth rate. So let’s look at
valuations using the GDP growth rate.
C. With a 4% growth rate, the valuations are:
PepsiCo:
3.269 3.429
Value of equity 2010 13.455
1.09 1.09 (1.09 1.04)
= $79.37
Coca-Cola:
2.653 2.803
Value of equity 2010 13.527
1.09 1.09 (1.09 1.04)
= $67.39
Coke’s value in now almost the same as the market price, PepsiCo’s still above the market price.
This exercise tells you how sensitive valuations are to the long-term growth rate, g. We need
to get a handle on this and will do so through the financial statement analysis in the next part of
the book. It appears here, that, with the same growth rate, PepsiCo is a more attractive stock to
buy than Coke. But note that we have applied the same 4% growth rate for every year from 2012
onwards. It may be that these firms will have a growth rate of 4% in the very long-run (as they
become like the average firm in the economy), but may sustain a higher growth rate in the
immediate term (say for 2012-2018). From that point of view, Coke, with a 5.67% growth rate in
2012, might be able to sustain a higher growth rate for a few years. Thus the $67 valuation might
be low.
D. One expects high growth rates to revert to the average growth rate the economy in the
long-term. (That average is often taken as the GDP growth rate.) That is because, growth
gets competed away: firms lose their competitive advantage and just earn like the average
firm. Thus one might expect the 2012 growth rates here―4.89% for PEP and 5.67% for
Coke―to drop in the future. Of course, it a firm is protected from competition, it might
be able to sustain challenge from competitors, and these two firms are protected by their
well-established brands (that are different to duplicate). They have “built a moat around
themselves,” as it is said, and thus have durable competitive advantage. On the other
hand, consumer tastes change, from carbonated drinks to “healthy” juice-based drinks.
E. Clearly, at a price of $67 relative to the valuations in (B) with the analysts’ growth rate,
the market expects the long-term RE growth rates to be lower than the analysts’ growth
for the near-term. Indeed, the market is pricing Coke with a growth rate of 4% after 2012.
F. There is an important asset missing from the balance sheet: the firms’ brands. With assets
missing from the balance sheet, one expects the P/B ratio to be high (as book value is
low). As earnings from the brands are in the numerator of ROCE, but the brand assets are
missing from the denominator, one expects the ROCE to be high. Of course, residual
earnings valuation has a built-in correction for the missing assets on the balance sheet:
book value is low, but one adds a lot of value to book value with a high forecast of ROCE
and residual earnings.
G. $67 seems to be a fairly safe price to buy at. That is the price with a 4% growth rate for
Coke, and PepsiCo is underpriced at the growth rate. Yet both are forecasted to have a
growth rate higher than 4% in the near term. So one would not be particularly nervous in
paying $67. But are analysts’ forecasts of RE and the 2012 growth rates reliable? Best to
do our own financial statements analysis and forecasting to check.
