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The Coca-Cola Company Message Board

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  • Novalis_97 Novalis_97 Apr 2, 1998 8:41 PM Flag

    Value = present value of cash flows, not

    I'll use the two-stage dividend growth model to compute Coke's intrinsic value, given Coke's cash flow growth rate averages 15% (more realistic than 5%) for the next decade and then drops to a constant 5% forever. I don't see any reason why Coke cannot continue growing cash flow by 15% a year for the next decade, especially given Coke's expansion into foreign markets and Project Infinity.

    1998 -- year-end cash flow = $3,662 mil. * 1.15 = $4,211.3 mil.; discounting back 1 year to year-end 1997 present value: $4,211.3 / (1.07)^1 = $3,935.794 mil.

    1999 -- year-end cash flow = $4,211.3 mil. * 1.15 = $4,842.995 mil.; discounting back 2 years to year-end 1997 present value: $4,842.995 mil. / (1.07)^2 = $4,230.059 mil.

    2000 -- year-end cash flow = $4,842.995 mil. * 1.15 = $5,569.444
    mil.; discounting back 3 years to year-end 1997 present value: $5,569.444 mil. / (1.07)^3 = $4,546.326 mil.

    You must contine this process up to and including year 2007. At that time:

    2007 -- year-end cash flow = $12,882.46 mil. * 1.15 = $14,814.83 mil.; discounting back 10 years to year-end 1997 present value: $14,814.83 mil. / (1.07)^10 = $7,531.11 mil.

    Then, you add up all the year-end 1997 present value numbers. This adds up to $55,618.45 mil. So Coke is worth $55,618.45 mil. so far.

    In Year 11 (2008), assume Coke's cash flow growth rate drops back down to a conservative 5%. In that case, we can use the growing perpetuity formula again.

    2008 -- year-end cash flow = $14,814.83 mil. * 1.05 = $15,555.57 mil. Present value in Year 10 of cash flow growing 5% a year: $15,555.57 mil. / (0.07 - 0.05) = $777,778.7 mil. Then, discount this value back to year-end 1997: $777,778.7 mil. / (1.07)^10 = $395,383.3 mil.

    $55,618.45 mil. (from above) + $395,383.3 mil. = $451,001.7
    mil. So Coke's intrinsic value at the end of 1997, assuming a 15% cash flow growth rate for the next decade followed by
    constant 5% growth, was $451,001.7 mil. Given Coke had 2,470.718 bil. shares outstanding at that time, Coke's intrinsic value per
    share at that time was $451.0017 bil. / 2,470.718 bil. shares outstanding, or $182.5387 per share. Coke's 1997 closing price was
    $66.6875 per share, and would have represented a margin of safety or discount of ($182.5387 - $66.6875) / $182.5387 = 63.5%.

    This is the HIGH side of the possible range of Coke's intrinsic value at the end of 1997. As I said previously, the low side was $81.

    At 81 1/8 right now, Coke is not overvalued, but rather it's at the very low end of its possible intrinsic value range.

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    • First, Norvalis, let me say that you are right on the money that cash flow is the only thing that matters in valuing securities; too many people are hung up excessively on accounting earnings.

      However, as JTD from Minnesota has implied, the problem in your valuation methodology is in the perpetuity formula you are using. The derivation you used for that formula is only correct if you assume that R is greater than G (source: Brealey-Myers "Principles of Corporate Finance", 1984 edition; this is as close to a Bible of Finance as you will find in graduate business education), which is not true in your example.

      The formula you use for the present value of a growing perpetuity, PV = C/(R - G), where PV = present value, C = cash payment (or annual cash flow in this example), R = discount rate and G = Growth Rate. This formula is meant to be used to determine how much you need to fund to produce a target cash flow stream in real terms given an assumed rate of return you can earn on an investment (R) and an assumed annual growth in expenses (G).

      If you still think your perpetuity formula is correct, consider the following. You assumed a 5% growth rate for KO beyond
      2007. Obviously, if this growth rate was higher, KO should be worth more, right? Increase the growth rate from 5% to 6%, the
      denominator in your equation goes from .07-.05 = .02 to .07-.06 =.01. THE VALUE DOUBLES! This can't be true and it isn't. Increase the
      growth rate in cash flow to more than 7% and you have a negative value for the perpetuity, which clearly makes no sense.

      This goes to show the danger of using formulas without plugging a few numbers in each direction in the formulas to ensure that common sense directional relationships hold.

      I would amend your valuation in 2 ways:

      1. 7% is too low for the discount rate. Investors can get about 6% WITH ABSOLUTE CERTAINTY in long government bonds. While
      KO's cash flows are predictable, there is no way that a 1% risk premium is enough to assume a 15% growth rate in cash flow for
      the next 10 years. The appropriate rate to use is KO's weighted average cost of capital. Unfortunately, as you probably know,
      calculation of WACC is not an exact science. I think the 12% Stern Stewart assmption for KO's WACC is awfully conservative; I'm
      comfortable with 9-10%.

      2. Like you, I run the cash flows out for 10 years; at the end, instead of the perpetuity formula, I assume that the company is liquidated as a going concern and the cash proceeds distributed to the shareholders. As the WACC, the appropriate value for the terminal value multiplier is anybody's guess. If you assume KO would have a 10% growth rate for the next few years and then tapers off from then, a multiplier of 20-25 times terminal cash flow seems reasonable to me.

      Since the values chosen for WACC and the terminal value multiplier influence the implied instinsic value of KO stock so
      significantly, I'll take a different approach and solve for what assumptions the market seems to have built in the current stock price.
      Here's what I come up with: a 15% growth rate in cash flow for 10 years; liquidation after 10 years at 22 times 2007 cash flow and
      a 9% discount rate. Those assumptions get me to an stock price of $80.22 per share, about where we are now. Those seem like
      reasonable assumptions to me, so I would conclude KO is fairly valued.

      Interestingly, either a 1% change in the discount rate or the annual growth rate for the next 10 years affects the stock price by $5-$6. If you think KO's annual growth rate in cash flow is going to be 18 instead of 15 over the next 10 years, fair value goes to $100. However, if you think the growth rate of 15% is reasonable but the WACC for KO should be 12% instead of 9%, fair value goes to $65.

      • 3 Replies to Beethoven_57
      • This was a great post. Extremely informative.
        However, I'm curious why you downplay earnings
        since, in the case of KO, they are directly related
        the amount of cases Coke sells.

        Although cash is very important, I'm not sure it should
        be given any more status over earnings. Especially in
        companies that have extremely high fixed assets or
        ongoing capital expenditures.


      • Rickson9 writes: "The use of a 6% discount
        rate today is absurd." Beethoven57 writes: "7% is too low for the discount rate."

        Well, maybe so, but I understand that Warren Buffett discounts at the 30-year bond rate, which is now LESS than 6%. His rationale is that he doesn't need a risk margin because it's already factored into his conservative estimates of growth rate.

        Maybe the 6% rate is absurd, and maybe Warren is just lucky.

        I'm sure that's it.

      • Hey, you guys forgot to factor in E=mc2. Just kidding. Although, I am struggling to follow your comments, I will be the
        first to admit that it is a tad over my head. However, that's how we learn. I do however disagree with the gentleman who stated
        that at the present growth rate, it would take 40 years to earn back your investment and if it doubled, then it would take 20
        years. Did we forget about the rule of 7s. I would think that the 40 year payback might be valid if an extremely lower growth rate
        were assumed. The PE is in the high 40s now. Therefore, the number of years for payback would equal the PE if there were no
        growth at all. An appoximate growth rate of around 2% would reduce that to 40 years. Did we forget the effect of COMPOUNDING?
        Therefore, if the growth rate remains steady, then a compounded growth rate of 5% would pay back the investment much quicker. My long
        winded diatribe focuses on this one point. Doubling the growth rate would cut the payback period more than half rather than just
        half. Maybe next, we can discuss the formula for Classic Coke and why this compound is so addictive.

        Brownie :-)

    • In the 1980's Japan did not care about p/e ratio either. Correct me if I am wrong but I think their market was around
      40,000. Today in the 15,000 range. I don,t care what anyone thinks a p/e for a company growing not flowing at 15 % to 20% a year is
      ridiculously high at 49 times earnings. My cost basis in ko is around $12 a share. If the stock was in a IRA I would sell today. I am
      starting to buy protective puts now. Good luck, maybe everyone else in the market is starting to think like Japan did in the 1980's.

    • I always appreciate the efforts of quantitative financial analysis, but your intrinsic value analysis of KO may be flawed.
      Two main weaknesses are: 1. How did you come to detemine that KO's discount factor is 7% ? Did you use BETA theory, or WACC?
      (Stern Stewart has KO WACC at 12%) Using 7% seems in error, if not just solely based on the fact that your Terminal Value (TV)
      after a 10 year analysis is still 87% of the total value. This is considered a high risk result, and should trigger re-analysis.
      2. Have you benchmarked your analysis? In other words, if you performed the same analysis on stock ABC would it also show a similar safety factor. It appears this analysis has not done so.
      IMO if you ever want to believe your valuation analysis, you must be able to benchmark against the market price over a
      period of time. This assumes a standardization to market efficiencies. Once you know what the market believes for stock ABC vs XYZ
      vs KO, then you can adjust model variables based on your own specific knowledge(perceptions) and see if you are bullish or
      bearish on a stock vs the market model. Most models of this type today will show that most stocks are overvalued. The question then
      must be asked is KO less overvalued than another reasonable alternative.

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