Coca-cola: a case study

January 27th, 2013

Coca Cola: a super-brand and a super investment?

Coca Cola is a world super brand and we know that Warren Buffett liked it enough to buy a large shareholding in the company, but has it been a good investment?

In January 2004, we examined Coca Cola in the terms set out below and asked whether it was a company that satisfied the Buffett principles. We thought that we might like to relook at that analysis and, in the context pf hindsight, see whether we should have bought into the company in 2004 and how it has gone since. We should also ask whether a panicky sale during the Global Financial Crisis would have been a good move. (Of course, selling anything just before the Wall Street collapse and buying back in was the right move but we are not Nostrodamus).

The 2004 Analysis

This is the analysis that we did in 2004.

In answering the question for ourselves whether Coca Cola is a company worth consideration as an investment, at the right price, we have used summary and other figures available from providers of financial information such as ADVFN. (Read why we use and recommend ADVFN).

Question 1: Does the company sell brand name products that are likely to endure?

The answer to this seems quite simple. The major product of the company has been around for many years, is sold worldwide and is considered one of the best-known brand names in the world. More importantly, its customers would not do without it, and have demonstrated a loyalty that makes it unlikely it would change to other products. It also has other well-known brands on its books – Sprite, Fanta, Evian, Minute Maid, PowerAde.

Question 2. Is the business of the company easily understood?

We think so. Its core operation is the production and distribution, both for itself and under franchise, of sodas and soft drinks and associated products.

Question 3. Does the company invest in and operate businesses within its area of expertise?

We would think so. Consideration of the Value Line information suggests that the company restricts itself to its core operations. We do not see it dabbling in areas outside its expertise.

Question 4. Does the company have the ability to maintain or increase profitability by raising prices?

The real question here is whether, if Coke were to lift its prices by a margin that would allow it to keep pace with inflation, sales would suffer. This is unlikely.

Question 5. Is the company, looking at both long-term debt, and the current position, conservatively financed?

a) Long term debt to profitability

The long-term debt of this company in 2002 was 2700 million dollars. The profit for that year was 4134 million dollars. At this rate, Coke could wipe out its long-term debt in .65 of a year, just over six months.

b) Current ratio

In 2002, Coke had current assets of 7352 million dollars and current liabilities of 7341 million dollars, a ratio of debt to assets of .99. This is lower than would be the desired ratio for industrial companies, but having regard to the nature of the business, and the ready cash flow, is acceptable.

c) Long term debt to equity

In 2002 the long-term debt was 2700 million dollars and shareholders equity was 11800 million dollars a comfortable ratio of .22.

Question 6. Does the company show consistently high returns on equity and capital?

The company has shown an average rate of return on equity over the past five years of 37.08%. In the same period, it showed an average return on capital of 33.6%. The figures are consistent.

1998 42.0 39.1
1999 34.0 31.5
2000 39.4 36.4
2001 35.0 31.9
2002 35.0 29.1
Average 37.08 33.6

Question 7. Have the earnings per share and sales per share of the company shown consistent growth above market averages over a period of at least five years?

The figures for this period are as follows.

Year EPS + or - % SPS + or - %
1997 1.64 7.64
1998 1.42 -13.4 7.63 -.13
1999 1.30 -8.45 8.01 +4.98
2000 1.48 +13.85 8.23 +2.74
2001 1.60 +8.11 7.06 -14.2
2002 1.66 +3.75 7.92 +12.18

Looking at a five-year rolling period, we can calculate the increase in earnings and sales over the rolling five-year period 1998-2002. For earnings, this is 16.9 %, for sales only 3.8%. The compound rate of return for earnings is 3.185, for sales, .75%.

This is not a strong rise in earnings or sales, and the question would be whether this is as a result of a slow-down in the US and world economies over this period or whether there is some more structural reason.

Question 8. Has the company been buying back its shares, and if so, has it bought them responsibly?

In 1998, the company had common shares outstanding of 2465.5 million. In 2002, the figure was 2471 million. The shares on issue are basically unchanged.

Question 9. Has management wisely used retained earnings to increase the rate of return to shareholders?

The company has the following earnings per share and dividend per share record over a five-year period.

1998 1.42 .60
1999 1.30 .64
2000 1.48 .68
2001 1.60 .72
2002 1.66 .80
Total 7.46 3.44

The company has therefore retained earnings totalling $4.02. In 1998, the shares reached a low of $53.6. In 2002, the shares reached a high of $57.9. An investor who bought at the lowest price in 1998 and still had them at the highest price in 2002 would have been showing a profit of $4.30. Thus the shares would have just slotted into Warren Buffett’s requirement for showing an increase in market value of a dollar for every dollar retained.

Using the approach of Mary Buffett and David Clark, we could calculate the percentage increase in earnings per share resulting from the retained profits. EPS in 1998 were 1.42, and in 2002 were 1.66, an increase of .24. Thus, from the total earnings retained of $4.02, earnings have increased by a total of .22, a percentage increase of 5.97%: not high.

Question 10. Is the company likely to require large capital sums to ensure continuing profitability?

Value Line suggests that in the two years following 2002, the company would be spending about .40 a share on capital items. The long-term average is .31, unadjusted for inflation. These figures seem to be in line with historical expenditures.

This case study is a demonstration only and is not intended to influence or persuade visitors to this site to make any investment decisions; they should make their own decisions, based on their own research, personal and financial circumstances, and after consultation with their own financial or investment advisers.

Should we have bought into Coke during 2004?

Looking at the above analysis, the only things that might have concerned us is the fact that retained earnings were perhaps not being used as wisely as they could have been and the growth rate a little low. On the other hand, the debt position and return on equity was excellent and it has a big moat - the competitive edge that Buffett so values. We could have bought into the company during 2004 at prices ranging between $15.63 and $20.07 (prices in today’s terms, adjusting for stock splits and dividends). Accepting that we would not necessarily have been able to anticipate the lowest price, let us say we might have been able to buy in at $17.85, the midway point between the two prices. (Historical prices and other statistics from ADVFN).

In 2002, the earnings per share were $1.66 (see above) - we cannot get figures for 2003, so we are working on the basis that they are the same, which is, we think, a conservative approach.   At a share purchase price of $17.85, this gives us a price/earnings ratio of 10.75, a more than acceptable ratio.

The interest rate payable on 10 year treasury notes during 2004 averaged out at about 4.25 per cent.  So, if we had $100 to spend, we could have chosen to buy US Government notes and earned  $4.50 (the interest rate payable on those notes) or to buy $100 worth of Coca Cola shares and earned $10.75 (the price/earnings ratio) based on our part-ownership of Coca Cola. We don’t think any company is as safe an investment as the US Government, but we think that, based on the above analysis, Coke is much less than double the risk. On this basis, a purchase of Coca Cola shares in 2004 would, we think, have been in accordance with the investment principles that we believe Warren Buffett applies.

The current price is around about $37.00, so we would have been in front, the price rising by 107 per cent (the amount of the price rise $19.15 multiplied by 100 divided by the initial cost $17.85) in 8 years, representing compound growth of around about 9 per cent. By way of comparison, the Dow Jones Industrial Index, at the extremes, was about 10300 in 2004 and is now around 13900, a rise of about 34.95 per cent (the rise in the value between 2004 and 2013 - 3600 - multiplied by 100 and divided by the value in 2004 - 10,300).

So, Coca Cola has risen in value at a rate 3.06 times (107 divided by 34.95) that of the market as a whole, assuming the Dow Jones Industrial Average is the benchmark.

In the stock market crash of 2008, shares on Coca Cola went down to as low as $18.22, not as much of a fall as many other shares, probably reflecting investors’ faith that people will still be drinking Coke, no matter what.  Some people got out of the market at this time, some people stayed and some people bought - individual decisions, reflecting individual opinions, fears and personal financial position. We don’t know what we would have done - getting out then would still have resulted in a small capital profit but, in hindsight, those who stayed have seen good resulting gains.

Posted by Julian Livy on January 27th, 2013 | Posted in Case studies |