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Thirsty For Income? Consider This Strategy

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I read an article extolling the virtues of PepsiCo (NYSE: PEP). The author said that he believed that Pepsi would continue to increase its dividend, and they might grow earnings faster than analysts expect. He also made the comment that their cash flow from operations compared to their dividend looked good. I can't say that I disagree with most of his thesis, but I would suggest investors think outside the box when it comes to generating income. Though there are several beverage companies that should provide a good yield to investors in this environment, there is a less well known company where the income stream might be even better.

This Is No DRIP Of A Strategy
If you are a long-term investor, a choice between Coca-Cola (NYSE: KO) or PepsiCo is a common conundrum. On the one hand, Coca-Cola has been the leader in both volume and earnings growth for a while. The company has several of the world's most well loved brands. PepsiCo on the other hand, has the Pepsi franchise and Frito-Lay. Both companies have long histories of raising their dividends. 

Many investors choose to buy their shares and reinvest the dividends through a DRIP (dividend reinvestment plan). If you buy shares in Coca-Cola, you'll get a yield of about 2.7%. By reinvesting your dividends, you can increase your effective yield over time. You can do the same with PepsiCo and start with a slightly higher yield today at just under 3%.

In the last few years, Pepsi's free cash flow payout ratio dropped from 58% to 56%. The company's free cash flow has been growing at about 11% annually. Prior to 2008, 15% dividend increases were the norm. After 2008, the average increase was about 6%. Coca-Cola's free cash flow payout ratio has increased from 62% to 66%. The company usually increased their dividend by over 11% until about 2008, and then 7.6% increases became the norm.

For Those Who Want More
However, what if you are an investor who is willing to take on more risk? Is there a way to trounce these yields of 2.7% and 3%? In short, yes there is, but it depends on what you think of options. By writing covered call options, you can potentially generate significantly more income than collecting dividends. 

In order to “write” a covered call you have to own 100 shares of the stock. You essentially agree to rent your 100 shares to someone else for a certain amount of time. You “write” or “sell to open” the call option and you get paid a premium. The great thing about covered calls is you keep the premium no matter what happens.

What Do You Do?
First, you pick a price that you are willing to sell your shares at. Usually a price just above the current price gives you more income. You can use this strategy with Coca-Cola or PepsiCo, or go in a different direction and choose SodaStream (NASDAQ: SODA)

For those who don't know, SodaStream is the company that produces the popular SodaStream machines. In case you haven't heard, SodaStream allows you to make soda or other sparkling beverages at home. The company suggests that their product is better for the environment, costs less per serving, is more convenient, and is a healthier option. The stock has done well recently, and the company has consistently beaten earnings estimates.

How Much Can You Make?
Once you've selected your price, you “write” your call option. Here is an example of the type of up front yield you can get with a covered call.

<table> <tbody> <tr> <td> <p><span><strong>Name</strong></span></p> </td> <td> <p><span><strong>Price</strong></span></p> </td> <td> <p><span><strong>Option</strong></span></p> </td> <td> <p><span><strong>Premium</strong></span></p> </td> <td> <p><span><strong>Up Front Yield</strong></span></p> </td> </tr> <tr> <td> <p><span>Coca-Cola</span></p> </td> <td> <p><span>$37.44</span></p> </td> <td> <p><span>Feb. '13 - $37.50</span></p> </td> <td> <p><span>$41.00</span></p> </td> <td> <p><span>1.09%</span></p> </td> </tr> <tr> <td> <p><span>PepsiCo</span></p> </td> <td> <p><span>$72.59</span></p> </td> <td> <p><span>Feb '13 - $72.50</span></p> </td> <td> <p><span>$81.00</span></p> </td> <td> <p><span>1.11%</span></p> </td> </tr> <tr> <td> <p><span>SodaStream</span></p> </td> <td> <p><span>$48.40</span></p> </td> <td> <p><span>Feb. '13 - $50</span></p> </td> <td> <p><span>$168.00</span></p> </td> <td> <p><span>3.47%</span></p> </td> </tr> </tbody> </table>

(assumes $7 commission for the option and $7 to buy the shares)

In Coca-Cola and PepsiCo's case, you get around 1% up front. If the stock doesn't reach your option price, you keep your shares and can write another option next month. If the shares go above your option price, you have to sell your shares, and in Coca-Cola's case you make a small gain, in Pepsi's case you lose a small amount. Either way, this strategy would theoretically give you better income than collecting the company's dividend for the year. Keep in mind these are monthly yields not annual, so Coca-Cola at 1.09% is the equivalent of 13.08%, if you could write a similar option each month for a year.

Greater Risk = More Pop
SodaStream is a more volatile stock than either Coca-Cola or PepsiCo. However, with greater risk comes greater reward. As you can see, SodaStream pays 3.47% in just one month. In theory, you could write this one option and make more in one month than collecting dividends from Coca-Cola or PepsiCo for the whole year. The worst thing that can happen is the stock goes down. In that situation, you keep your shares and your premium. The best thing that can happen is the shares go up, you keep your premium and a capital gain from the sale of the shares. 

The bottom line is, income oriented investors have options beyond just collecting a dividend. If you are interested in covered calls, most brokers offer tutorials and information about how these options work. In addition, Fool.com offers a fairly comprehensive list of definitions and information about options here. Trading options isn't for everyone, but if you are looking for better income and aren't opposed to selling your shares if they go up, take a look at covered calls.

MHenage owns shares of SodaStream. The Motley Fool recommends Coca-Cola, PepsiCo, and SodaStream. The Motley Fool owns shares of PepsiCo and SodaStream. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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