KO Analysis

8/3/2019 KO Analysis

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As most everyone knows, Warren Buffett received much of his

initial investing education from the father of modern security

analysis, the venerable Ben Graham. Personally, I attribute most

everything I know about investing from reading the teachings of

both Ben Graham and Warren Buffett. To me, it only made senseto learn as much as I could from the very best. These two

distinguished and legendary investors certainly meet the criteria.

Therefore, I was very excited to come across several pieces of Mr.

Graham's work courtesy of ValueHuntr titled: Common Sense

Investing: The Papers of Benjamin Graham written by Benjamin

Graham.

From as best I can tell, most of these papers were written in the1970s, and therefore require a modest amount of interpretation

and extrapolation to make them relevant to modern times.

Nevertheless, these papers contain many pearls of Ben Graham's

investment acumen and wisdom. As I was conducting routine

research on the Coca-Cola Company (KO), it struck me that

Warren Buffett may have been violating several of Ben Graham's

most important lessons by owning Coca-Cola stock over the last

15 or so years. The following excerpts from Ben Graham's paperscited above speak to my contention regarding Mr. Buffett's

possible mistake.

"The Past and Future of Common Stocks.Before I came down

to Wall Street in 1914 the future of the stock market had already

been forecast-once and for all-in the famous dictum of JP. Morgan

the elder: "it will fluctuate." It is a safe prediction for me to make

that, in future years as in the past, common stocks will advancetoo far and decline too far, and that investors, like speculators-

and institutions, like individuals-will have their periods of

enchantment and disenchantment with equities."

My interpretation of the above is that Mr. Graham was simply
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pointing out two related realities regarding the stock market. The

first is that the stock market will fluctuate, and the second is that

these fluctuations are not always rational or intelligent. In other

words, when enchanted stock prices can get too high, and when

disenchanted stock prices can get too low. For most of the past15 years or so, I believe the stock market was enchanted with

Coca-Cola Co. (KO). More simply stated, Warren Buffett was

holding Coca-Cola for many years when it was dramatically

overvalued.

Frankly, this confuses me because I'm certain that Mr. Buffett

knew what he was doing. Even considering his philosophy and

policy of being a long-term holder of a good and profitablebusiness that he understands, holding Coca-Cola at such high

valuations seems like a mistake too obvious for him to make.

Most importantly, as we will soon see below, this mistake spanned

a time frame of between 12 to 15 years. This completely rewrites

the definition of being patient beyond what most mere mortals

are capable of.

A few additional excerpts from the same section of Ben Graham'spapers offered an interesting analysis of how mispricing by the

stock market could be recognized. In what follows, Mr. Graham

offers an interesting comparison between stock values and bond

interest rates in order to determine or recognized intrinsic value.

"It seems logical to me that the earning/price ratio of stocks

generally should bear a relationship to bond-interest rates.

viewing the matter from another angle, I should want the Dow orStandard & Poor's to return an earnings yield of at least four-

thirds that on AAA bonds to give them competitive attractiveness

with bond investments."

I found it both intriguing and astute that Ben Graham would relate
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stock values to their competitiveness versus interest rates and

quality bonds. To me, true investing principles always had to

make sense, and this notion of Ben Graham's makes a great deal

of sense logically and mathematically. At the end of the day, I

believe an investment receives its value from the amount of cashflow it generates for its stakeholders. With common stocks, the

cash flow that is usually measured is earnings. Finding the right

multiple with which to capitalize earnings at, is ultimately what

value is all about. Therefore, Mr. Graham's idea that you should

expect an earnings yield on your stock that is greater than the

yield you can earn on a AAA bond (four-thirds) makes good sense.

Coca-Cola By the Numbers: 1992 to Current

"Fundamentals at a Glance"

The following earnings and price correlated F.A.S.T. Graphs

reviews Coca-Cola Company (KO) by the numbers, from 1992 to

current. The orange line on the F.A.S.T. Graphs plots Coca-

Cola's earnings-per-share utilizing a modified version of Ben

Graham's formula (GDF=Graham Dodd Formula) for valuing astock. The essence of this research tool is that it calculates

intrinsic value based on fairly capitalizing earnings. As you can

see, Coca-Cola grew earnings at a compounded rate of 9.8. The

orange line with white triangles capitalizes Coca-Cola's earnings

and a PE ratio of 15.

The black line on the graph plots monthly closing stock prices for

each year. Based on the formulas utilized by the F.A.S.T. Graphsresearch tool, fair value would exist when the black price line

touches the orange line. The blue line with asterisks plots a

calculated historically normal PE ratio of 20, which in Coca-Cola's

case implies a quality premium afforded to this stalwart.

Nevertheless, Coca-Cola stock price was dramatically above
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calculated fair value for most of this time frame. Note that the

stock price peaked in June of 1998 and then trended down until it

finally reverted to the mean in February of 2009.

The calculated performance including dividend income from 1992to current depicts Coca-Cola (KO) as an almost perfectly average

holding. Both capital appreciation and total dividend income was

almost identical to the returns generated by the S&P 500.

Theoretically at least, Coca-Cola, based on earnings growth,

should have generated its shareholders capital appreciation of

just under 10% (9.8% EPS growth) with an added dividend kicker.

However, the fact that their stock price was overvalued in the

beginning and less overvalued at the end accounts for its only

generating 6.2% capital appreciation. On the other hand, Coca-

Cola's dividend and dividend growth was much more correlated

and functionally related to its earnings.
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Coca-Cola: Obviously Overvalued in 1998

The F.A.S.T. Graphs below looks at Coca-Cola (KO) over the time

period 1992 through 1998. What is clear from the graph is that

starting in 1994, Coca-Cola's stock price became increasinglyovervalued until it peaked in June of 1998. At its closing price on

December 31, 1998, Coca-Cola was trading at a PE ratio of 47.5,

which was more than 3 1/2 times its 13.3% compounded earnings

growth rate. Therefore, its PEG ratio of 3.57 was excessive even

though the company was growing earnings at low double-digit

rates.


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The following F.A.S.T. Graphs produces a table that calculates

Coca-Cola's earnings yield at this time. Most importantly, the

earnings yield is compared to what could have been earned from

an equivalent $100,000 investment in Coca-Cola versus a 10 year

treasury bond. This chart offers the benefit of 20/20 hindsight as

it calculated that Coca-Cola (KO) grew earnings at the rate of

8.1% from the beginning of 1999 to the end of 2008. What thechart shows is that in 1999 and 10 year treasury bond provided a

yield of 4.66%. Therefore, an investor would have received a total

of $46,600 of riskless interest.

In contrast, Coca-Cola (KO) would have only generated $33,011 of

total earnings of which it would have paid out only $14,044 in

total cumulative dividends. In other words, Coca-Cola Company's

earnings yield was only 70% of what could have been earned, andpaid out from a 10 year treasury bond. From an income

perspective, treasury bond holders would have received over

three times as much riskless interest than Coca-Cola shareholders

would have received in dividends over the same time frame. This

is a far cry from an earnings yield "of four-thirds that on a AAA
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bond" that Mr. Graham wrote about.

Coca-Cola 1999 to 2008: An earnings only perspective.

The following F.A.S.T. Graphs plots Coca-Cola's earnings and

dividends only (no stock prices) from 1999 to 2008 in order tooffer a perspective on the importance of valuation. From the

graph it is clear that Coca-Cola (KO) generated pretty good

operating results (earnings) through a period that included the

recession of 2001. The light blue area indicates dividends paid to

shareholders out of the green shaded earnings area. Therefore,

from this perspective, Coca-Cola's business was decent and their

dividend well covered.


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This next F.A.S.T. Graphs simply adds monthly closing stock

prices and shows two important facts. First of all, it shows how

massively overvalued the company's stock price was at the

beginning of 1999. Next, the graph shows how the stock price

steadily trended downward over the entire 10 year period

primarily due to its overvaluation. Notice that the company's

earnings growth rate was also a little slower here, packaging only6.2%. However, it was more due to overvaluation than to the

slowing earnings growth that cause stock prices to behave so

poorly.
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When you calculate the performance associated with owning

Coca-Cola (KO) stock over the 10-year period 1999 to 2008, the

risk and devastation that overvaluation brings becomes vividly

apparent. Even though the company's earnings performed at a

reasonably decent level, shareholders would have seen their

principal erode to the tune of more than 32%. Even when you add

in dividend income, which was very generously distributed,shareholders still found themselves underwater.


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Coca-Cola: Present and Future

When you look at Coca-Cola (KO) as it sits today, we find that its

stock price has twice reverted to the mean, or came into value

(touch the orange line). However, since June of 2010 it once again

appears to be approaching a rich valuation. On the other hand,

today's valuation is nothing like it was during the irrational

exuberant period described above. Suffice it to say that we don't

believe that Coca-Cola represents a bargain at today's levels.


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Conclusions

I hope the reader considers that the intention of this article was

not to dish Warren Buffett or to challenge his investing acumen.

Quite the contrary, I am a long-term admirer of this legendary

value investor. Perhaps I will admit to being a little jealous of his

ability to hold a position like Coca-Cola even when it was soovervalued. I don't believe my clients would have been able to

muster that much patience. So I guess you could say that I also

admirer the relationship he has forged with his loyal client base.

Furthermore, I also understand that Coca-Cola was only a small

portion of his overall portfolio and that the dividend income he

received from his holdings was able to fund additional attractive

investments.

The main reasons I authored this piece was to illustrate the

importance of sound valuation. Even the best of companies, and

Coca-Cola certainly fits that category, can become dangerously

overvalued when markets are behaving irrationally. Additionally, I

hope this piece brought some insight into the importance of
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earnings and dividends as they apply to investment results. The

markets may not always be rational, but if we understand sound

value investing principles, we can behave rationally regardless of

what the market is doing.

The opinions in this document are for informational and

educational purposes only and should not be construed as a

recommendation to buy or sell the stocks mentioned or to solicit

transactions or clients. Past performance of the companies

discussed may not continue and the companies may not achieve

the earnings growth as predicted. The information in this

document is believed to be accurate, but under no circumstances

should a person act upon the information contained within. We donot recommend that anyone act upon any investment information

without first consulting an investment adviser as to the suitability

of such investments for his specific situation.

Charles (Chuck) C. Carnevale Co-Founder and Chief Investment

Officer ofEDMP, Inc. He has been working in the securitiesindustry since 1970. Prior to forming EDMP, he was a partner in a

30-year-old established registered investment advisory in Tampa,

Florida. Chuck holds a Bachelor of Science in Economics and

Finance from the University of Tampa. Chuck is a sought-after

public speaker who is very passionate about spreading the critical

message of prudence in money management. Chuck is a Veteran

of the Vietnam War and was awarded both the Bronze Star and

the Vietnam Honor Medal
http://www.edmpinc.org/http://www.edmpinc.org/

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