In 1988, Warren Buffett stunned the financial world when he purchased 94 million shares of Coca Cola. No other financial guru saw this as a good investment. Buffett acquired 93.4 million share, for a total investment of $1.023 billion. By the end of 1989, Coca Cola represented 35 percent of Berkshire common stock portfolio. It was a bold move.
What caused Buffett to purchase? There was no distressed pricing. But rather, according to Buffet, the company was undervalued. The market felt the company value was $15.1 BILLION. He felt it was worth anywhere from $20.7 billion (based on a 5 percent growth in owner earnings) to $48.3 billion (based on a 15 percent growth). So, like Benjamin Graham, Buffett felt there was a huge margin of safety-the discount of intrinsic value. This ranged from a conservative low of 27 percent to a high 70 percent. Other investment gurus looked at Coke as overvalued.
By 2008, Buffets investment in coca cola has grown considerably. He owns 8.6 % of the company, and it is worth 12.274 billion dollars. But would Buffett buy it today if he was considering it for investment? Or would he buy its rival, Pepsi Cola? Let us take a closer look.
Background
Coke, symbol KO NYSE, is the worlds largest manufacturer, marketer, and distributor of carbonated drink concentrates and syrups. It began in 1986 and is now sold in more than 195 countries worldwide.
Originally intended as a patent medicine when it was invented in the late 19th century by John Stith Pemberton, coca-cola was bought out by businessman Asa Griggs Candler, whose marketing tactics led Coke to its dominance of the world soft drink market throughout the 20th century. The Coca-Cola Company makes Coca Cola and Diet Coke, which has become a major diet cola. However, others exist, including caffeine-free coca-cola, diet coke caffeine-free, cherry coke, coca-cola zero, vanilla coke and special editions with lemon and with lime and even with coffee.
Pepsi symbol PEP NYSE was first made in the 1890s by pharmacist Caleb Bradham in New Bern, North Carolina. The brand was trademarked on June 16, 1903. There have been many Pepsi variants produced over the years since 1903, including diet pepsi, crystal pepsi, pepsi twist, pepsi max, pepsi samba, pepsi blue, pepsi gold, pepsi holiday spice, pepsi jazz, pepsi x -available in Finland and Brazil, pepsi next-(available in Japan and South Korea, pepsi raw, pepsi retro in Mexico, pepsi one, and pepsi ice cucumber in Japan. It also makes and sells frito lay products.
According to consumer reports, in the 1970s, the rivalry continued to heat up the market. pepsi conducted blind taste tests in stores, in what was called the "pepsi challenge". These tests suggested that more consumers preferred the taste of Pepsi (which is believed to have more lemon oil, less orange oil, and uses vanillin rather than vanilla) to coke. The sales of pepsi started to climb, and Pepsi kicked off the "challenge" across the nation.
In the U.S., pepsi's total market share was about 31.7 percent in 2004, while coke's was about 43.1 percent. Overall, coca-cola continues to outsell Pepsi in almost all areas of the world. Saudi Arabia, Pakistan, the Canadian provinces of Quebec and Prince Edward Island and the U.S. states of Michigan and South Carolina are the exceptions.
So let us begin our evaluation, through Warren Buffet eyes.
Are coke and pepsi crrently buffet type companies?
A basic principle for Buffett is that his type of company has a "durable competitive advantage" as compared to being a "price competitive" or "commodity" type of business. Companies with a "durable competitive advantage" are more likely to be found in these sub-industries: brand name fast food restaurants, brand name beverages, brand name foods, brand name toiletries and household products, brand name clothing, brand name prescription drugs, advertising, advertising agencies, TV, newspapers, magazines, direct mail, repetitive services for businesses, low cost producers of insurance, furniture, or low cost retailers. While you should be easily able to explain where the company's pricing power comes from -i.e. a strong regional brand image, a business tollgate, its main products are #1 or # 2 in its field and has been on the market for years and hasn't changed at all, a consumer or business ends up buying the same product many times in a year, etc. or having the lowest production cost among its competition- there are certain figures that one can look at that can qualify the company as having a durable competitive advantage.
Both of These Are Buffett type companies.
Copyright (c) 2008 Barry Lycka
HAS THE COMPANY BEEN BUYING BACK SHARES: Buffett likes to see falling shares outstanding, which indicates that the company has been repurchasing shares. This indicates that management has been using excess capital to increase shareholder value. Coca Cola's, KO's, shares outstanding have fallen over the past five years from 2,441,530,029 to 2,343,000,000, thus passing this criterion. This is a bonus criterion and will not adversely affect the ability of a stock to pass the strategy as a whole if it is failed. Pepsi, or Pep- NYSE, shares outstanding have fallen over the past five years from 1,705,000,000 to 1,612,000,000, thus passing this criterion. This is a bonus criterion and will not adversely affect the ability of a stock to pass the strategy as a whole if it is failed.
Advantage-Tie
"SHOULD I BUY AT THIS PRICE?" Although a firm may be a Buffett type company, he won't invest in it unless he can get a favorable price that allows him a great long term return.
CALCULATE THE INITIAL RATE OF RETURN:
Buffett compares his type of stocks to bonds, and likes to see what a company's initial rate of return is. To calculate the initial rate of return, take the trailing 12-month EPS of $2.47 and divide it by the current market price of $54.37. An investor, purchasing KO, could expect to receive a 4.54% initial rate of return. Furthermore, he or she could expect the rate to increase 4.6% per year, based on the 10 year average EPS growth rate, as this is how fast earnings are growing. For Pep, we, take the trailing 12-month EPS of $3.57 and divide it by the current market price of $69.90. An investor, purchasing PEP, could expect to receive a 5.11% initial rate of return. Furthermore, he or she could expect the rate to increase 11.0% per year, based on the analysts' consensus estimated long term growth rate, as this is how fast earnings are growing.
Advantage-Pepsi
COMPARE THE INITIAL RATE OF RETURN WITH THE LONG-TERM TREASURY YIELD:
Buffett favors companies in which the initial rate of return is around the long-term treasury yield. Nonetheless, he has invested in companies with low initial rates of return, as long as the yield is expected to expand rapidly. Currently, the long-term treasury yield is about 4.60%. Compare this with KO's initial yield of 4.54%, which will expand at an annual rate of 4.6%, based on the 10 year average EPS growth rate. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.
For Pep, the long-term treasury yield is about 4.60%. Compare this with PEP's initial yield of 5.11%, which will expand at an annual rate of 11.0%, based on the analysts' consensus estimated long term growth rate. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.
Advantage: Pepsi
CALCULATE THE FUTURE EPS: KO currently has a book value of $10.03. It is safe to say that if KO can preserve its average rate of return on equity of 28.8% and continues to retain 45.75% of its earnings, it will be able to sustain an earnings growth rate of 13.2% and it will have a book value of $34.62 in ten years. If it can still earn 28.8% on equity in ten years, then expected EPS will be $9.98. PEP currently has a book value of $10.66. It is safe to say that if PEP can preserve its average rate of return on equity of 30.3% and continues to retain 60.89% of its earnings, it will be able to sustain an earnings growth rate of 18.5% and it will have a book value of $58.03 in ten years. If it can still earn 30.3% on equity in ten years, then expected EPS will be $17.60.
Adv- Pepsi
CALCULATE THE FUTURE STOCK PRICE BASED ON THE AVERAGE ROE METHOD:
Now take the expected future EPS of $17.60 and multiply them by the lower of the 5 year average P/E ratio (21.8) or current P/E ratio (current P/E in this case), which is 19.6 and you get PEP's projected future stock price of $345.00. If you take the EPS growth of 4.6%, based on the 10 year average EPS growth rate, you can project EPS in ten years to be $3.87. Now multiply EPS in 10 years by the lower of the 5 year average P/E ratio (23.0) or current P/E ratio (current P/E in this case), which is 22.0. This equals the future stock price of $85.15. Add in the total expected dividend pool of $17.30 to get a total dollar amount of $102.45.
Advantage-Pepsi
CALCULATE THE EXPECTED RETURN USING THE AVERAGE EPS GROWTH METHOD: Now you can figure out your expected return based on a current price of $54.37 and the future expected stock price, including the dividend pool, of $102.45. If you were to invest in KO at this time, you could expect a 6.5% average annual return on your money. Buffett likes to see a 15% return, and would even go down to 12. For Pepsi, $69.90 and the future expected stock price, including the dividend pool, of $225.37. If you were to invest in PEP at this time, you could expect a 12.4% average annual return on your money. Buffett likes to see a 15% return, but nonetheless would accept this return.
Advantage-Pepsi
RANGE OF EXPECTED RATE OF RETURN:
Based on the two different methods, you could expect an annual compounding rate of return somewhere between 12.4% and 18.2%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 15.3% on PEP stock for the next ten years, based on the current fundamentals. Buffett would consider this a great return, thus passing the criterion. For KO, based on the two different methods, you could expect an annual compounding rate of return somewhere between 6.5% and 15.9%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 11.2% on KO stock for the next ten years, based on the current fundamentals. Buffett accepts a 12% return, although 15% is preferable. This return is unacceptable to Buffett, thus failing the criterion.
Adv- Pepsi
Conclusion
If Buffett were to buy today, Pepsi would be the better buy.
Barry Lycka has sinced written about articles on various topics from Hair Styles, Beauty Tips and Aging. Dr. Barry Lycka is president of , the worlds number one source for online guidance.. Barry Lycka's top article generates over 60500 views. to your Favourites.