Stock Valuation the Stock That I Chose Term Paper

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Stock Valuation

The stock that I chose is PepsiCo. I was drinking a Pepsi when I was thinking about a stock to do, and it just seemed like a good idea. That is why I picked the stock, but PepsiCo (PEP on the NYSE) is a major blue chip stock so there is no reason why I shouldn't pick it. The current stock price of PepsiCo is $85.31

PepsiCo is in the food and beverage industry. They manufacture, bottle and distribute mostly soft drinks and snacks. According to the annual report, the company is split 51% food and 49% beverage and has the same split for U.S. revenue and non-U.S. revenue. Two-thirds of the company's business comes from the Americas. Frito-Lay is the major food company and Pepsi is the major beverage company. The company also owns Quaker Oats, which is the owner of Gatorade and Tropicana. This is considered the "healthy" part of the PepsiCo portfolio.

The overall economy can be measured using data from various agencies. The Bureau of Labor Statistics highlights a 7.6% unemployment rate and 0.5% consumer price index (CPI) meaning that unemployment is fairly high, but lower than it has been. Inflation is fairly low, but higher than it has been. These are signs of a growing economy, in particular one that is recovering from a slowdown. The Bureau of Economic Analysis covers the GDP figures, and indicates an increase of 1.8%, which is a fairly slow rate of increase. Worse, personal income only increased 0.5% in May, 2013. This figure is more important for PepsiCo, because it sells to consumers and it sells discretionary products. The more personal income people have, the more money they will have to waste on soda and chips. However, if the economy is growing, that will help. There is also a lot of growth in emerging economies, something that PepsiCo is trying to get involved with. However, two-thirds of their money comes from the Americas so that is the most important.

Strengths and Weaknesses of PepsiCo

PepsiCo is a major player in the food and beverage industry. It is either a market share leader or the number two in many categories. PepsiCo has mainly a strength with respect to the economy. PepsiCo's products are discretionary purchases, so the company can expect to see improving sales if personal income in particular rises. The economy right now is not strong per se, but it is improving, and Pepsi remains well-positioned to take advantage of this. The company is also working to take advantage of growth in emerging markets.

Pepsi has a very good position in the industry, usually number one or two in any given market. Interbrand ranks Pepsi as the 22nd best brand in the world. This is a source of strength, but Coke is #1 so only a moderate strength. It is great that everybody has heard of Pepsi and respects the company, but ideally it would have a better brand than its major competitor. That said, Pepsi is much stronger than any other competitor. This gives it several advantages in the market. Consumers know the brands, so brand extensions are easier. Distribution is easy -- it is not hard to convince retailers to take on new products or give more space to existing products because they have established sales. Further, competition is often dissuaded from entering markets where very strong players already exist. Few would dare to take on Pepsi (and Coke) head to head, and the same can be said for Frito-Lay, which is a dominate snack company.

At the firm level, PepsiCo has recently completed a restructuring to give it more strength. It bought key distributors to bring them back in house. This deal a few years ago was intended to "save money and get new products to market more quickly" (Fredrix, 2010). This flexibility is a strength. Another strength lies in PepsiCo's brands, which are highly valuable and well-recognized. The company also seems to have strong management and marketing that have allowed it to have such good market position and billions in sales. The competitive position might be one weakness, but Pepsi may also seek to improve innovation and efficiency. These two areas are ones where Pepsi can make improvements.

Valuation Methods

To determine whether or not PepsiCo is a growth company or not is the first step. Regression of the revenues shows significant growth in the past five years. However, most of that growth came from purchasing its bottlers in the U.S. The past couple of years with economic recovery have barely seen any growth in PepsiCo's earnings so it makes sense that this is not really a growth stock. It merely gained revenue by investing in its own business. Thus, the constant dividend growth model will be used as the first valuation method.

The constant dividend growth model is based on the idea that the company's stock should represent the present value of future cash flows. If the company is not a growth stock, then the future cash flows are mostly going to come from the dividends, and any growth that there is in those dividends. No reasonable investor would pay for growth that may never come to pass.

The formula for the constant growth dividend discount model is

P = dividend / (discount rate -- growth rate)

For PepsiCo, the current dividend is $2.13 per share. The growth rate can be understood from looking at past dividends and the average growth rate of these:

Table 1 Dividends

2012

2011

2010

2009

Dividends

2.13

2.03

1.89

1.78

Dividend Growth

4.9%

7.4%

6.1%

7.8%

This gives an average dividend growth in the past five years of 6.6%. The next step is to determine the discount rate for the company. This would be done using CAPM and the WACC. For CAPM it is assumed that the risk free rate is the one year Treasury rate, which is 0.15%. The market risk premium is 7%. The beta for PepsiCo is 0.48. These figures are then used to price out the cost of equity for PepsiCo:

Cost of Equity = Risk free rate + Beta*Market Risk Premium

= 0.15 + 3.36 = 3.51%.

Then the cost of debt is determined. Pepsi just issued bonds a couple of days ago, and it was noted that yield of PepsiCo debt is 0.88% at this time for 2016 bonds (Gangar, 2013). Then to complete the WACC calculation, the capital structure of Pepsi needs to be taken into account:

Weighted average cost of capital = weight of debt * cost of debt + weight of equity * cost of equity

WACC = (.702)(.88) + (.298)(3.51) = .6177 + 1.045 = 1.66%

The WACC is then used in the constant growth dividend discount model:

2.13 / (1.66 -- 6.6) = 0.

The conclusion here is that Pepsi is overvalued. The dividends are growing at a faster rate than the discount rate. This situation reflects that Pepsi has a lot of debt, but also that its cost of capital is very low. With interest rates at very low levels, Pepsi borrows at a very low rate. However, its cost of equity is lower than the dividend growth rate. The company has grown its dividends rapidly in the past five years, probably because the stock price has not been growing. However, since the stock price delivered by the dividend discount model is not higher than the current stock price, this indicates that Pepsi is probably overvalued.

Another valuation model is the residual income model. The residual income is the net income less the cost of equity. The net income for Pepsi is $6.178 billion. The cost of equity is 3.51% as outlined in the section on the dividend discount model. The total equity outstanding is $22.417 billion. So the residual income is $6.178 - $.786 = $5.392 billion. The next step in this method is to take the book value of the firm and to it add the present value of the expected future residual income:

BV + PV (EFRI)

$22.417 + (5.392/0.0166) = $347 billion. There are 1.544 billion shares outstanding, so the value of a share by this method would be $224.74. The residual income method is best for companies that are not turning a profit and do not pay dividends, neither of which apply to PepsiCo.

The next three methods of valuation are similar, in that they equate the current level of valuation with past levels. These are price/earnings, price/cash flow and price/sales. The historic levels of these valuations are applied to expectations of next year's levels for these figures. The following table outlines the projected valuation by each of these three methods.

Table 2 - Valuations

Pepsi

Avg level

Current

Next Year

Price Next Year

P/E

18.9

3.96

3.955

$74.75

P/CF

13.2

$72.62

P/S

2.2

65492

69319

$98.77

The average P/E ratio was taken for the past five years. The average P/CF level was taken for two years, because of the fundamental change relating to the purchase of the distributors…

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