Today, I'd like to talk about soda. It has no nutritional value. It has lots of sugar. It usually has caffeine, an addictive drug. Soda just bad for you, all around. Yet it makes up nearly 30% of all liquids consumed in America. That's why Coca-Cola is my favorite company.

As always, it is important to determine whether Coca-Cola has a "moat," that is, a sustainable competitive advantage. I see two important advantages: The company's brand name, and its distribution system.

As you may know, Coke outsells Pepsi by a wide margin, both in America and Worldwide. But people actually prefer the taste of Pepsi to Coke in taste tests. More importantly, people overwhelmingly choose to buy Coke or Pepsi rather cheaper store brands. There is a wide range of feelings that people attach to the Coca-Cola brand. A Coke drinker might think that Coca-Cola is more refreshing than Pepsi. A Pepsi drinker might think that Coke has no flavor. If our Coca-Cola fan drinks Coke and Pepsi in a blind taste test, there's a pretty good chance that he won't find the "blind" Coke to be more refreshing than the "blind" Pepsi. A Pepsi fan will probably react similarly. Their feelings most likely come from the brand, rather than the drink itself. Now suppose a Coke drinker can choose between spending $1.25 on a 2 liter bottle of Coca-Cola and 89 cents for a store brand. They know what Coca-Cola tastes like and trust the brand. They identify with the brand. They might feel foolish if they are seen drinking some no-name store brand. Coca-Cola costs only a few cents more, so why not buy it?

Even when people do buy store brands, they can only do so when they're at a store. Coca-Cola is available in far more situations. If you go to a restaurant, you expect to be able to order a Coke. There are vending machines all over the place. Wherever you are, chances are, you're not very far from a Coca-Cola beverage. Store brands can't duplicate this. Imagine walking into a restaurant and ordering a Safeway Select cola.

Suppose your friend Joe wants to start his own soda company, Joe's Cola. Now Joe tries to get his product sold in the stores, but why should the grocery stores give him shelf space? They can make more money devoting that space to Coca-Cola products. So then, Joe tries to get a restaurant to sell his product. Why should they, when people will never order it by name? He needs to develop a brand. But if he can't sell his product, he can't afford to spend big bucks on marketing. Why, then, would people buy his soda? Even if he manages to create a strong, regional brand, how does he get his product distributed all around the world? Warren Buffett has said, "If you gave me $100 billion and said take away the soft drink leadership of Coca-Cola in the world, I'd give it back to you and say it can't be done."

We have established that Coca-Cola has an unassailable competitive position. Now, we must figure out whether people will continue to drink Coca-Cola in the future. Around the world, soda consumption rarely decreases. Here in America, soda consumption steadily increased for over a hundred years, although recently it has become stagnant. If soda preferences change rapidly in a given country, it's usually because soda is becoming more popular, not less. The past 100 years tell us that when the people of a country start drinking soda, they continue to do so. When people become health conscious, they don't switch to healthy drinks. They switch to Diet Coke.

In America, soda makes up nearly 30% of all liquids consumed. Coca-Cola has 40% of the soft drink market, and sells other drinks as well (such as Dasani bottled water and Minute Maid orange juice). Coca-Cola produces more than 1/8 of all liquids consumed in America.

Soda is nearly as popular in Mexico as it is in America. Coca-Cola has more market share in Mexico, and overall, Mexicans consume more of Coca-Cola's products than Americans do. Mexico is a relatively poor country, yet they can afford to buy nearly as much soda as we do in America.

Worldwide, Coca-Cola has 50% of the soft drink market. Only 2.6% of all liquids consumed are Coca-Cola products. This is because the majority of the world's population live in extremely poor countries, like China and India. In those two countries, a can of Coca-Cola costs about 25 cents. Sounds cheap, but for a farmer in China, 25 cents is a lot of money. If China's economy improves, people will be able to drink a lot more soda. China does not have to be particularly prosperous for this to happen. As we know from Mexico, a country's population can be relatively poor and still consume a lot of soda.

To value Coca-Cola, we will need to break up its growth rate into smaller components, each of which we will estimate separately. We will then have a growth estimate. Next, we will calculate the company's future free cash flow. Finally, we will enter this data into this website's intrisic value calculator.

Up until around 1997, Coca-Cola's volume had been growing at about 7 to 8% per year. After 1997, volume growth slowed considerably, and has fluctuated from around 1% to about 5%. The company has dramatically reduced its volume growth expectations, first from 7-8% to 5-6%, and then from 5-6% to 3-4%. If world economy does not improve, volume growth might be even less than 3-4%. But if and when people in China, India, Africa, etc can afford to buy lots of soda, I think volume growth will be higher. So I see 3-4% as a conservative estimate.

Now assume that volume grows at 3-4% over the next 25 years. If the world's population grows at 1% per year, then per capita consumption will increase by about 2.5% per year. Now 1.025²⁵ = 1.85, so our estimates predict that, in 25 years, Coca-Cola will have 1.85 times its current 2.6% share of worldwide liquid consumption. So we estimate that 2.6%*1.85 = 4.8% of all liquids consumed in the world will be Coca-Cola products. Since Coca-Cola owns 50% of the worldwide soft drink market, this looks reasonable to me.

If Coca-Cola's prices increase by 2% per year due to inflation, then we predict that Coca-Cola's revenues will grow by 3.5% + 2%, or 5.5%.

Companies like Coca-Cola, Anheuser Busch, Wrigley and Colgate, which have extremely powerful brands, tend to increase their profit margins over time. New technology helps them improve costs, and due to their strong competitive position, they don't have to pass all these savings on to their customers. Furthermore, Coca-Cola is growing internationally, which should let them take advantage of economies of scale, particularly in developing countries. I think it is reasonable to assume that margin improvements will add about 1% to earnings growth. So our total earnings growth estimate is 5.5% + 1%, or 6.5%.

During Coca-Cola's high growth days, the company's free cash flow was about 85% of its net income. Now, since its growth rate is much lower, free cash flow should be higher as a percentage of income. Free cash flow is defined as: net income + depreciation + increase in non-interest bearing current liabilities - capital expenditures (cap ex) - increase in non-interest bearing current assets. Over the past several years, Coca-Cola's cap ex has been roughly equal to its depreciation. Next year, Coca-Cola expects to spend $1 billion on capital expenditures. Depreciation was $900 mil last year. Now suppose that Coca-Cola's revenues grow at 5.5% this year. We can predict that its depreciation will be 900 million * 1.055, or 950 million, next year. Then cap ex will exceed depreciation by $50 million. This is about 1 percent of the company's net income.

Now we can estimate the company's non-interest bearing current assets by looking at its balance sheet and adding inventories, accounts receivable, and "prepaid expenses and other assets." They may be earning interest on some of their receivables, but we will assume that all of these assets are non-interest bearing. This information can be found in the company's 10-K report. For Coca-Cola in 2004, we get $5,326 million in non-interest bearing current liabilities. If this grows at 5.5% next year, we can predict that these assets will rise by 5.5%, or $293 million.

We can estimate that the company's non-interest bearing current liabilities is equal to its "accounts payable and accrued expenses." For Coca-Cola, we get, $4,283 million. If this grows at 5.5%, then it will increase by $236 million.

So our free cash flow estimate is its net income + $950 mil + $236 mil - 1000 mil - $293 mil, or net income minus $107 mil. $113 million is about 2.2% of the company's next income, so we predict that the company's free cash flow will be 97.8% of its net income.

Alternatively, we can use the formula: expected free cash flow is approximately equal to: net income X (return on equity - growth rate) / (return on equity). Coca-Cola's return on tangible equity is 43%, and our expected growth rate is 5.5%. So (return on equity - growth rate) / (return on equity) = [(43-5.5)/43] = 87%. Therefore, we can predict that Coca-Cola's free cash flow will be approximately 87% of its net income. Let's adjust this estimate further. Coca-Cola has about $6,091 million in property, plant and equipment. $6,091 million X 5.5% = $335 million. So we are predicting that, in the next year, Coca-Cola will add $335 million to its property, plants and equipment. Coca-Cola thinks that next year's cap ex will be only $1,000 mil, and this is only $50 mil higher than our predicted depreciation. So, Coca-Cola's management only expects to add about $50 mil to its property, plant and equipment. This suggests that our estimate is $285 mil too high. $285 mil is about 6% of Coca-Cola's net income, so our estimate for Coca-Cola's free cash flow, as a percentage of its net income, was six percentage points too low. That is, we can predict that Coca-Cola's free cash flow will be 87% + 6%, or 94%, of the company's net income.

The reason for the discrepancy: Coca-Cola earns large stakes in bottlers, which are counted on the balance sheet as "long term investments." This adds considerably to the company's equity. These investments do affect Coca-Cola's free cash flow, and here's why: when Coca-Cola's bottlers grow, they are forced to invest a lot of money on new equipment, meaning, they have little free cash flow. When Coca-Cola owns between 20% and 50% of a company, it is required to record its proportion of the investee's net income as "equity income." So, if a bottler is growing, Coca-Cola's proportional share its the bottlers' free cash flow is far less than its equity income. If we are trying to calculate Coca-Cola's free cash flow, we should look at Coca-Cola's proportion of its investees' free cash flow, not its proportion of its investees' income.

We know that future growth is going to require large investments. So I expect free cash flow to be less than 97.8% of net income (our first guess). Perhaps 90-95% would be a reasonable guess.

Now, visit the intrinsic value calculator. Enter $2.06 into the Earnings Per Share field. Enter 10 as your discount rate. Enter 6.5 in each of the growth rate fields. Enter 0.9 in the "Free Cash Flow/Net Income" fields. Enter 3 in the terminal growth rate field. Enter .95 as the "Terminal Free Cash Flow/Net Income."

Using these estimates, we get a value of $43.73 for the stock. If we assume that Coca-Cola's future free cash flow will be 95% of its net income, our value increases to $45.47. If we assume that the company's growth rate will pick up in the future (when the citizens of developing countries can afford to buy Coca-Cola) then the value increases.

Coca-Cola's tax rate is an unusually low 22%. Part of this is because Coca-Cola earns significant profits in countries that have low tax rates. I don't think this tax rate is sustainable. Because of this, the company's value needs to be adjusted downward.

Conclusion:

I don't make buy or sell recommendations, but Coca-Cola is a great company, and its price seems reasonable. As always, you should do your own research before making any investments.