Coca-Cola and Pepsi are long-time rivals in the soft drink industry. In terms of their primary markets, the two have been engaged in an intense battle for market leadership for decades. While this makes them natural comparables as investments go, they are significantly different in a number of other ways and this makes the question of which is the better investment a more challenging debate. Pepsi has spun off its bottling enterprises into a separate company, Pepsi Bottling Ventures, while Coca-Cola uses third party bottlers under contract. Pepsi has historically been the more diversified of the two companies, with its current businesses including Lay's and Quaker Oats/Gatorade. The nature of competition in the soft drink industry is international for both firms, but it is also intense. For both firms, the core soda products are viewed strategically as cash cows, but gains in market share and shelf space often come from new product introductions -- a high rate of innovation is needed just to maintain one's place in the soft drink industry. This paper will analyze these two leading soft drink companies in order to determine which of the two will make the better investment. Particular emphasis will be given to the use of ratio analysis as a technique.
The first type of ratio that will be used to analyze these two firms is their liquidity ratios. Liquidity ratios reflect the ability of the firm to pay meet its short-term debt obligations. The main liquidity ratio is the current ratio, which is defined as the current assets divided by the current liabilities. The current ratio for Coca-Cola (KO) is 1.16 and the current ratio for PepsiCo (PEP) is 1.10. There is little to choose between the two companies with respect to their present current ratios. Historically, PepsiCo has had a better current ratio, so the recent performance of the two companies appears to have changed with respect to liquidity.
Profitability Indicator Ratios
Profitability indicator ratios measure the ability of the firm to convert inputs such as assets and equity into profit. Two key profitability indicator ratios, therefore, are the return on assets and the return on equity. MSN Moneycentral publishes this information but the basic formula is Net Income / Avg. Total Assets (Equity). For KO the ROA is 19.7% and the ROE is 42.3%. For PEP, the ROA is 8.8% and the ROE is 27.5%. Thus, KO is the superior performer with respect to these measures. This would generally imply that Coca-Cola is the more efficient operator of the two, but as Pepsi is more diversified that is to be expected. Still, the outperformance for Coca-Cola is clear on the profitability indicator ratios.
The debt ratios measure the long-term solvency of the firm. They reflect the ability of the firm to meet its long-term debt obligations, as opposed to the liquidity ratios that are focused on short-term debt obligations. The debt ratio is the key measure of solvency. The debt ratio for Coca-Cola is 57%, and for PepsiCo it is 68.9%. This means that PepsiCo has a higher degree of leverage. While the initial reflection is that Pepsi's financial condition is worse because it has more debt, it should be remembered that the optimal capital structure differs for every company. Thus, it is best to see if a pattern has been established with respect to this variable. That is not the case. PepsiCo has been rapidly growing its debt load in recent years. Coca-Cola has also seen its debt load increase, but not at the same level as the increased at Pepsi.
The next type of ratio is the operating performance ratio. The ratio used for this type will be the fixed asset turnover ratio. This ratio measures the degree to which fixed assets are converted to revenue. It is not the most applicable ratio for soft drink producers, as they rely far more on their intellectual property. Indeed, PepsiCo does not bottle its own product, which should give it a higher fixed asset turnover relative to Coca-Cola. This is indeed the case. PepsiCo has a fixed asset turnover off 3.64, whereas Coca-Cola has a fixed asset turnover of 2.89. This ratio breaks down simply -- Pepsi has a higher average level of fixed assets. This supports its non-soda businesses, and ultimately Pepsi is able to generate significant revenues from both its soda and non-soda businesses. With Coca-Cola, the company has a smaller amount of fixed assets, but has a significant smaller revenue base, again reflecting the relationship differential between fixed assets and revenues at these two firms.
The next ratio to be considered is the dividend payout ratio. While this is irrelevant as a gauge of the firm's cash flow, the dividend payout ratio is useful for investors, to understand how much of the firm's earnings will be paid to them and how much will be reinvested into the company in the form of retained earnings. According to MSN Moneycentral, the dividend payout ratio for Coca-Cola is 1.88% and for PepsiCo it is 2.06%. These figures are similar, but the cash flows that an investor will get from Pepsi are clearly going to be higher relative to the company's stock price, compared with those of Coca-Cola.
The next step is to determine the investment valuation ratio. This is the value that the market puts on the stock relative to its earnings -- thus it is the market's determination of the growth potential of the company. For Coca-Cola, the P/E ratio is 12.61 and for PepsiCo the P/E ratio is 18.46. This means that the market believes Pepsi has slightly higher growth potential than does Coke. When taken in consideration with the dividend payout ratio, it is evident that Pepsi has higher growth prospects and a higher level of immediate payout in the form of dividends. PepsiCo looks the better of the two on both counts, but the higher P/E also makes it more expensive for an investment today.
The company with the most satisfied stockholders is going to be Pepsi. The stockholders want return for their income. These two companies are operating in a business that by all reasonable estimations can be considered to be mature. Thus, these industries should be cash cows -- they should generate income for the stockholders. Generating capital gains is not something that should be expected from these companies because they are in mature businesses and both companies already operate around the world so there is little in the way of opportunity for international growth. Thus, stockholders want return that is guaranteed and they want it at a good price. Pepsi pays more in its dividends, but the market also believes that PepsiCo has higher growth potential than does Coca-Cola. For an existing shareholder, the higher P/E probably means that all other things being equal a stockholder in Pepsi has seen slightly higher capital gains than a stockholder in Coca-Cola. The result of this is that with higher capital gains and a higher dividend the stockholders of Pepsi are the most likely to be satisfied, in comparison with the stockholders of Coca-Cola.
As an investor, I would choose Pepsi as the better investment. There are two reasons for this decision. The first is that I view both companies as being mature, so I rely on the company that has the greater level of dividend payout. As an investor, I want more of the firm's cash flow and PepsiCo delivers this. In addition, the market at least believes that PepsiCo has the better growth prospects. At this point, the investor pays for that growth, but if the growth expectations are correct then PepsiCo also delivers that as well, compared to Coca-Cola.
One possible reason that PepsiCo makes the better investment from both a dividend and growth perspective is that it is the more diversified of the two companies. PepsiCo is efficient with its use of assets, and with the different product lines it can find growth where Coca-Cola cannot. There are still parts of the world where Frito-Lay is not dominant, something that cannot be said for the soft drink businesses of these two companies. The result of that is that PepsiCo is more likely to exhibit growth through diversification. In addition, PepsiCo being the smaller of the two in terms of the soft drink business has greater growth potential than does Coke -- it is further down in the market and therefore has further to climb.
Diversification, however, is just one of the non-financial criteria that I would look at when choosing between two different countries. The product life cycle is important for the growth component of a stock's price, and for the dividend component as well. A company early in the life cycle can have a high stock price on the basis of its potential growth, but a company in the latter stages of life will see its shareholders want returns immediately in the form of dividends rather than in the form of long-term capital…