The Battle of the Cola Dividends
Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Warren Buffett many years ago made a bet that people around the world would always drink Coke. One of his most famous purchases was a large stake in Coca-Cola (NYSE: KO), 400 million shares which today are worth nearly $15 billion. Of course, Buffett bought all of his shares back in 1988 when he felt that the price was right. Today, Coca Cola is a wide-moat behemoth of the beverage industry, a distinction which typically carries with it a premium in price.
One way to determine if Coca-Cola is reasonably priced is to look to the dividends. The company started paying a dividend in 1920 and has increased the dividend every year for the past half-century. This kind of consistency is highly desired in a dividend stock. Coca-Cola's main competition is PepsiCo (NYSE: PEP), which sells both beverages and snack foods. The flagship products of both companies, Coke and Pepsi respectively, have been battling each other for market share for the better part of a century. Smaller competitor Dr. Pepper Snapple Group (NYSE: DPS) was spun off from Cadbury Schweppes in 2008, although the beverage Dr. Pepper has been selling in the United States for over a century.
All three companies have similar dividend yields. Coca-Cola has the lowest yield with 2.76%, followed by PepsiCo and Dr. Pepper Snapple both with a yield of 3.01%. Let's look at the dividend history for the last decade for each company to see how fast these dividends grew.
KO dividends are adjusted for split
Coca-Cola has grown its dividend at an annualized rate of 8.77% over the last 10 years and 6.06% over the last 5 years. PepsiCo has a much higher 10-year growth rate of 12.94% but a lower 5-year growth rate of just 5.21%. I'm going to eliminate Dr. Pepper Snapple from the running for two reasons. First, the company has only been paying a dividend for 3 years, which is not a long enough track record to be confident in the stability of the dividend. Second, DPS just doesn't have the scale and the reach of the two larger companies. The company derives most of its revenue from the United States, while Coca-Cola and PepsiCo have substantially greater exposure to emerging markets. These markets will be the main drivers of growth going forward, and DPS is so far missing out.
The next thing which needs to be compared is the payout ratio. This quantity tells you how much of a company's profits go to dividends. I use free cash flow in this calculation instead of earnings. A high payout ratio could mean that the dividend growth will be slow or stopped altogether, while a low payout ratio could mean higher near-term growth. Historically, this is how the payout ratio for Coca-Cola and PepsiCo has looked.
PepsiCo's superior dividend growth rate early in the decade was a result of starting from a lower payout ratio compared to Coca-Cola. In the last 5 years both companies had a payout ratio hovering around 60%. This leads me to believe that all of the future dividend growth will come from earnings growth, and that the 5-year growth rate calculated above for each company is a reasonable guide for the future.
Which Stock Is The Best?
I'll use the dividend discount model to estimate the fair value of both stocks. I'll assume that the dividend will grow at the 5-year rate calculated above for the next 20 years and then by 3% perpetually thereafter. Given the wide-moat status of both companies I feel that the long period of higher growth is justified. I'll use a discount rate of 8%, which is roughly the long-term growth rate of the market as a whole.
The Bottom Line
Neither company is cheap. Coca-Cola currently trades at $36.98 per share, a 17% premium over my fair value estimate, while PepsiCo currently trades at $71.34 per share, a 21% premium to my fair value estimate.
Both companies were more reasonably priced near the beginning of 2012, but the shares have increased in price since then. I don't think either one gives you a combination of yield and growth sufficient to justify a position unless you're willing to accept a lower return. There are plenty of better dividend stocks out there that are just as reliable - McDonald's is a good example. I don't recommend either Coca-Cola or PepsiCo until share prices come down or yields go up to justify the price. They're both great companies, but the price is just not right.
TheBargainBin has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola and PepsiCo. The Motley Fool owns shares of PepsiCo. 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!