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Today, Would Warren Buffett Buy Coca Cola or Pepsi? Part 3

Sep 1, 2008
Let's look at some intriguing numbers.

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.
About the Author
Barry A. S. Lycka is editor of http://www.LesTout, the world's premier sight for consumer guidance. See htpp://www.LesTout.com
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