Part-II Case- Coca-Cola Co. Analysis [pic] How much overall risk is there in the company? Discuss the methods used arrive at this estimate. There are two ways to look at the risk Beta and standard deviation. One of the most popular indicators of risk is a statistical measure called beta which measures the stock’s volatility in relation to the market (measures the market/unique risk) Beta of 0. 59 measures the financial and business risk for Coca Cola in other words referred as the levered beta for Coca Cola Company. To calculate the business risk of coca cola we will use unlevered beta which comes down to ? u=? /(1 + (1-0. 228)0. 2) = 0. 511–>business risk. Standard deviation is a statistical measurement that sheds light on historical volatility. This measures the total risk of the company. Total risk = 2. 38 For standard deviation we took the stock price from 27. 07. 2009 to 19. 07. 2010 date. Then we calculated weekly holding period (HPR) i. e. (Pt+1-Pt/Pt) and we found weekly returns. From these numbers we computed Annual actual return by using the formula 1+EAR= (1+HPR) n. Using S&P500 returns for Coca Cola from the previous year i. e. 2009 we also tried to calculate R- squared of the firm which comes down to 28. 4%. R-squared measures the % of stocks variance that is explained by the market. Pepsi’s R-squared 27. 33%. Let’s see the below tables. We computed values for Pepsi as well for comparison as it till date remains Coca Cola’s biggest competitor. What we analyzed is that Pepsi’s total risk profile is lower than Coca Cola but this also accounts in the factor of size of both. | | |Beta |Standard Deviation |Return | |COCA COLA |KO |0. 59 |2,38% |10,4% | |PEPSI |PEP |0. 7 |2,20% |18,8% | | |Return |Standard deviation | |S&P 500 (Market) |13,7% |2,52% | The explanations are as follows. ? Coca Cola has very low beta which is 0. 59. it is not correlated with market risk. ? Coca Cola has the most total risk as measured by the standard deviation which is 2. 38% ? Coca Cola has the greater beta (0. 59) and will add more risk to diversify when we compare between Coca Cola and Pepsi. Where is the risk coming from? Market, firm, industry, or currency) Business Risk and Financial Risk have been discussed above but we feel it would be appropriate enough to share some information on Coca Cola’s foreign exchange risk as 70% of their revenues are coming from abroad; hence, Coca Cola has a high exchange risk exposure since their financial statements are presented in dollars and they need to convert at the end . After reading a report and understanding Coca Cola deep market share in Europe we can understand that it was being affected by the weak euro but it has placed itself well by taking a Put Option to cover the down side.
Also there are some health concerns related to Coca Cola’s carbonated drink. It has a sweetened chemical HFCS which raises concerns about obesity and poses negative impression on the brand. Coca Cola has a big brand name and it has to be very careful about it. Other than that Coca Cola faces some challenges from the business side of its risk mainly from China where it is still struggling to get the market share due to tough competition. Not only that it relies heavily on its bottlers for their products and faces a big risk from its operations.
Recently it has been trying to acquire its bottlers to reduce such risks especially in North America. Coca Cola’s growth prospects as compared to industry are relatively stable but do face constant threat of innovation as its competitors are equally innovative. Coca Cola faces an indirect threat from increased taxes in U. S. or other operating countries which may affect its future earnings. Financial Risk= debt to equity ratio increasing but not of a concern. Liquidity Risk= Quick Ratio= 0. 95 ( has been increasing for the past 5 years which shows that it has been improving its ability to quickly convert assets into cash ); Debt/Ratio= 0. (due to its long term debt been increasing as its been buying back its shares and acquiring its North American Bottling Plants). How does this company’s risk level compare to other firms in the industry? If its risk portfolio is different, what is the cause of this? Pepsi Co Beta = 0. 57 Snapple Group Beta = 1. 17 Coca Cola Beta = 0. 59 In terms of market size Coca Cola is the biggest player up to date in the market. Its biggest competitor Pepsi has almost the same company structure and entails almost/relatively the same risk profile i. e. relative low debt ratio; stable growth prospects; low WACC etc..
Other growing players such as Snapple Group and Nestle’ have relatively high debt ratio which leads to higher cost of debt, higher compensation for return on equity and therefore, higher WACC. These growing market players in the carbonated beverage industry have a better growth prospects as they still need to tap into various emerging markets. Do you expect the risk profile to change over time? Discuss the reasons for your expectations? As far as risk profile is concerned we can see a slight increase in its debt ratio for the past three years.
This is mainly because of fears of how they were dependent on their bottlers to get their product and in financial distress times their supply was disrupted due to that. Hence since then they have been actively taking charge of buying most of their bottling plants in North America. More importantly in 2007 Coca Cola had announced to buy back certain number of shares over the course of 4 years and hence it does need capital do that. So, slight increased debt portion in the portfolio reflects a slightly lower WACC than before. Overall Coca Cola is a well diversified brand and it has its operations spread out.
Individual project risks can be checked up with bottom up beta and risks can be compensated for that. Also a reason why Pepsi has a lower beta its due to its snack business and when calculating bottom up beta, risks get eliminated and a better estimate is evolved. How does the current cost of capital for this company compared to your estimation of its overall risk? Discuss your findings.? CAPM= rsf + ? ( rm- rsf ) = 2. 99+ 0. 59 ( 12. 3 – 2. 99) =8. 483% ? Here, we have taken return of market as 12. 3% (Avg. return of market for past years) ? Risk free rate= return on 10 year Treasury bond WACC = wd(rd)(1-T) +ws(rs) (0. 0962)(2. 6171) + (0. 9038) (8. 483) = 0. 2518 +7. 6672 = 7. 9190 % ? LTD+ Short Term portion of Long Term = 5,059 + 6, 800 = 11,589 ? Common Stock= 1. 99B ( No. of shares Afloat outstanding) * Current Share Price 54. 75 = 108. 925 Bn ? Preferred Stock = 0 Hence Total Value = 108,925,000000 + 11,589,000,000= 120. 514Bn Tax Rate for Coca Cola= 22. 8% (for 2009) Hence, cost of debt =rd (1 – T) = 3. 39 (1 – 0. 228) = 2. 6171 ? R-squared(Market Risk) for CocaCola = 28. 24% ? Business Risk= 1- R2 = 71. 76% What we can see is that the Coca Cola faces a much higher business risk than the market risk.
Which shows the company is very much diversified in terms of its risk profile but bears a big business risk for such a global firm as explained before (foreign exchange risk, political etc). Whenever the firm takes on more than optimal debt the cost of debt and equity increases which leads to increased WACC and this lowers the share price. But as long as the gearing ratio is optimal, WACC decreases and an increase in the stock price are reflected. When the gearing ratio increases, (which have been the case for Coca Cola in the past few years, although very slightly) the levered beta keeps increasing and becomes more correlated to the market.
Coca Cola can increase its debt to equity ratio a little more to further lower its WACC and increase its share price or do recapitalization which it is already doing to manage business risk vs. financial risk. If invested in Coca Cola Common Stock 5 years ago and sold it today, what would’ve been your return? Out performed or Underperformed? CocaCola Return Price on 07/16/05- $ 44. 03 Today 07/16/10 – $ 54. 75 Dividends over the years in total (2005-2010) = $7. 2 % increase for buying and selling = 40. 7% Pepsi Return Price on 07/16/05- $ 48. 32 Today 07/16/10 – $ 64. 45
Dividends over the years in total (2005-2010) = $7. 46 % increase for buying and selling = 48. 82% Market Return (S) Return on 07/16/05 = 1064. 88 Return on 07/16/10= 1234. 18 % return of market = -14. 71% ? What we can see clearly is that Coca Cola stock has outperformed the market but underperformed when compared to Pepsi. WHY COKE STOCK PERCEIVED A GOOD BUY? ? Have demonstrated steady earnings and sales growth. ? Boast competitive advantages over rivals. ? Hang tough during economic slowdowns. ? Have little or no need to borrow money and often pay a dividend. [pic] Discuss why there is a difference in the rating? | | | | | |Long Term Debt/ Capital |5059000 |48671000 |10% |AAA | |Total Debt/Capital |11859000 |48671000 |24% |AAA | |Operating Income/Sales |9301000 |30990000 |30% |AAA | |Return on Capital |6824000 |29858000 |23% |AA | |NI/(S.
E+LTD) | | | | | |Free Operating Cash flow/Total Debt |3893650 |11859000 |33% |AAA- | |Funds Flow/Total Debt |8750000 |11859000 |74% |AAA- | |EBITDA Interest coverage |10460000 |355000 | 29,46 |AAA | |EBIT Interest coverage |9301000 |355000 | 26,20 |AAA | | | | | | | |Our Overall Average AAA | | | | | |Morning Star Estimate AA- | | | | |
What we understand from the rating conflict is that we are rating the company to its current structure which seems attractive and good when compared to the rest of its competitors in such economic conditions but when we look at the growth and future prospects of Coca Cola Company, the picture seems blurred. Financial risks seem to be very few but business risks are of a greater concern. This is primarily because Coca Cola is already all over the world and analyst don’t know how this industry can grow further plus risks of sweet carbonated drinks being replaced by healthier risks may seem troublesome for the company. Along with all that country risks in which it operates and huge foreign exposures risks seem to give it a questionable rating in such economic times.