Thursday, December 13, 2012

How important is valuation?

There's several companies that I would like to own much larger stakes of.  One of these companies is Coca-Cola (KO).  They are a dividend champion with 50 consecutive years of dividend growth.  That's quite a feat.  However, given Coca-Cola's size and stability should you invest your hard-earned money in them no matter the valuation of the shares are?  Let's run some numbers for some hypothetical earnings per share (EPS) and dividend growth for the next 10 years and compare the possible returns.  Coca-Cola closed trading on Wednesday, December 12 at $37.64.

We'll use the growth numbers from my stock analysis on Coca-Cola.  For a recap, analysts expect Coca-Cola to increase EPS by 8.20% per year for the next 5 years and I've assumed that from then on they will increase EPS by 3.50%, which is approximately the long-term inflation rate.  I also assumed that they can increase their dividends (DPS) at 8.24% per year for the next 5 years and at 6.19% (0.75 x 8.24%) for the next 5 years.

YearEPSDPSPayout Ratio
1$2.00$1.0251.00%
2$2.19$1.1050.42%
3$2.37$1.2050.44%
4$2.56$1.2950.46%
5$2.77$1.4050.48%
6$3.00$1.5250.50%
7$3.11$1.6151.81%
8$3.22$1.7153.15%
9$3.33$1.8154.53%
10$3.44$1.9355.94%

In order to calculate the 5 year and 10 year returns I've assumed that shares of Coca-Cola will be trading at the average low PE ratio for the last 5 years which is 14.70.  Currently Coca-Cola is trading at a 19.68 trailing PE and a 17.19 forward PE, so over the time period there would be PE contraction which would reduce returns.  The 5 year share price would then be 14.70 * $2.77 = $40.78 and the 10 year share price would be 14.70 x $3.44 = $50.63.  Over the first 5 years you would have received a total of $6.01 per share in dividends and over 10 years that would be $14.59 per share.  Let's look at the return possibilities if the investment was made today at varying share prices to show how valuation matters.  Dividends will not be reinvested in this example.

Potential 5 Year Returns
Price PE @ Purchase Price App. Divi. Return Total Return CAGR
$37.64 17.19 8.33% 15.98% 24.31% 4.45%
$34.00 15.53 19.93% 17.69% 37.61% 6.59%
$32.00 14.61 27.42% 18.79% 46.21% 7.89%
$29.77 13.59 36.97% 20.20% 57.17% 9.46%

Potential 10 Year Returns
Price PE @ Purchase Price App. Div. Return Total Return CAGR
$37.64 17.19 34.50% 38.76% 73.26% 5.65%
$34.00 15.53 48.90% 42.91% 91.81% 6.73%
$32.00 14.61 58.21% 45.59% 103.80% 7.38%
$29.77 13.59 70.06% 49.01% 119.07% 8.16%
*All returns are not adjusted for inflation.

While it may seem pretty straightforward that you should purchase shares for the cheapest possible price but just how much of a difference are we talking about.  For every $1 invested in the 10 year return example at the $37.64 price you would have $1.73 after 10 years.  For the $34.00 price you would have $1.92.  For the $32.00 you would have $2.04 and for the fair value price of $29.77 every dollar invested would be worth $2.19.  That's a huge difference in values over a 10 year period with over 26% difference between purchasing at today's prices rather than waiting to purchase at fair value.  If we look at the 5 year returns, you only beat inflation by about 1% by investing at the current price rather than beating inflation by almost 6% by purchasing at fair value.

This is why I try and always purchase very close to my fair value calculations if not at lower prices.  I'll leave you with Warren Buffet's quote, "Price is what you pay.  Value is what you get."  Just quickly running through the numbers shows how true his statement is.

2 comments:

  1. Thanks for running through some KO scenarios.

    Boy I had a few KO limit orders the other month, I think it was November. There was some serious resistance at $36. The markets had some decent sized down days yet KO refused to go more than a few cents lower than 36. My limit orders never executed. I think at this point it's gonna be tough grabbing shares of Coke unless they have a poor earnings report or there is a massive market sell off. But hey it could all change in a few months, we never know!

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    1. CI,

      I too would like to own some more KO. I got a decently sized position in KO a while ago but could always use more. Unfortunately the opportunities to pick up KO shares on the cheap don't happen often or stick around for that long.

      Thanks for stopping by!

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