The Big Problem With Coca-Cola Stock

by Ed Elfenbein | October 18, 2012 1:07 pm

I’m still surprised by the high price that Coca-Cola (NYSE:KO[1]) is fetching. The stock closed yesterday at $37.74, not far from a 52-week high. I just don’t see how that’s justified.

Let’s look at some numbers. Earlier this week, the company reported Q3 earnings of 51 cents per share[2], matching Wall Street’s estimate. As we’ve come to expect with companies that do a lot of business outside the U.S., the strong dollar took a bite out of Coke’s profits. Revenue rose only 1% to $12.34 billion, which was $70 million shy of Wall Street’s estimate. The rising greenback knocked 5 percentage points off revenue growth and 7 points off operating income growth. That’s unfortunate, but I doubt that headwind will last.

1018ko The Big Problem With Coca Cola Stock[3]

Still, Coke is going for 17.1 times next year’s earnings estimate. I just don’t see how Coke can justify an above-market premium in an environment like this. Coke’s earnings growth for the next five years is estimated to be 7.43%, which is 2.75% less than what’s expected of the S&P 500.

The current quarterly dividend is 25.5 cents a share, which makes the payout ratio exactly 50%. For the S&P 500, the payout ratio is running close to 30%. Even with that high payout ratio, Coke’s dividend only comes to 2.7%. Many high-quality stocks are yielding much higher than that right now.

By my math, Coke’s fair value is close to $26. Perhaps investors see the Coke brand as similar to a U.S. Treasury. After all, there aren’t many better representatives of American capitalism that Coca-Cola. I think this way of thinking is a huge mistake, but I can see how some investors can justify a 17 P/E for Coke in a world where a five-year Treasury has a P/E of 130.

The major mispricing in the market right now is that investors are vastly overpaying for security, and are underpaying for risk. I believe this trend will slowly unwind — in fact, it’s already started. That explains why U.S. stocks have advanced this year even as earnings estimates have come down. The market is slowly reverting to normal.

Endnotes:
  1. KO: http://studio-5.financialcontent.com/investplace/quote?Symbol=KO
  2. 51 cents per share: http://investorplace.com/2012/10/coca-cola-matches-q3-estimates-with-higher-earnings/
  3. [Image]: http://investorplace.com/wp-content/uploads/2012/10/1018ko.gif

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