General

Coca-Cola Company (NYSE:KO) has just celebrated 50 years of consistent dividend growth; moreover, they have done everything necessary to maintain that dividend growth. Warren Buffett (the largest shareholder of Coca Colawith a 9.1% stake in the business), whose Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has averaged an annual gain topping 18% for 30 years, held his stock position since 1988 in Coca Cola recognizing how the company understands changing markets and portfolio adjustments. He noted in his1988 letter to shareholders that “We expect to hold [it] for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.” An investor considering a solid 10 year dividend stock opportunity should strongly consider Coca Cola in his portfolio. This article breaks down some basic value calculations for Coca Cola, following the many recent articles signaling a bearish outlook for the company.

Dividend Growth

Two indicators are used to estimate the value of the stock, dividend growth and earnings per share growth. The reason only these two meters are used is nature of Coca Cola. Because the company’s dividend grows on a year to year basis, the relationship between dividend growth and earnings per share (EPS) growth is a powerful pointer to the health of the company. When EPS growth cascades beneath dividend growth, dividend growth will correct itself (decline). To gain a clearer perspective of the present state of this association, the appropriate discount rate for Coca Cola is calculated, the simplest formula is:

Plugging in a 10 year government bond’s interest rate, current Coca Cola Beta, and a risk premium of 5% makes:

Now the average dividend growth rate is calculated in order to have an appropriate future dividend cash flow estimate. The average payout ratio established how consistent the dividend payments are relative to earnings per share (Diluted).

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Table 1: Calculating the average dividend growth rate.

In order for these future estimates to hold true two assumptions are made.

1. Coca Cola has consistently increased dividends for the last 50 years, betting against them to continue doing so seems mathematically improbable.
2. Coca Cola will be able to uphold its high dividend growth by fine-tuning to changing market demand. It is true that people are shifting away from carbonated drinks; however, Coca Cola is notoriously famous for keeping meticulous data, and to think they are not making the required adjustments, acquisitions, and re-evaluations for the changing demand seems naïve.

From here the dividend for 2014 is estimated, as Q1-Q3 data is released we did it as follows:

Table 2: Calculating the estimated dividend for Q4 & 2014. Source: Nasdaq

The Q4 estimates are averages of the previous three quarters. Using a dividend growth rate of 9.73% (as calculated above), and a discounting rate of 5.65%, a present value estimation of future dividends for the next 10 years can be made, subsequent to the $1.22 dividend estimate for 2014. As expected price per share is the unknown variable, we keep it constant at $41.5.

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Table 3: Calculating net present value of future dividends.

Because the expected price per share is constant, the present value of the stock would be the year 10 stock price discounted to present value.

Next the present value of dividends is calculated. To do so the sum of the row “PV of the dividends” $15.12 is obtained. The sum of the present value of the stock price in 10 years ($23.95) and the sum of future dividends at present value ($15.12) is equal to the theoretical mathematical value of the stock today (assuming stock price does not change, and only applicable to a dividend stocks similar to Coca Cola).

According to this calculation the stock is currently overvalued. Estimated stock price difference is $2.43. This difference is mostly reflected in people’s expectation for stock price appreciation; however the number seems very low. For this reason we calculate for the EPS growth necessary to increase the present stock price value to $41.57.

Stock Price

In terms of stock price growth rate the $2.43 reflects a public estimation of 1% yearly stock price appreciation over the next 10 years. If we recalculated Table 3 with the 1% adjustment it would change as follows.

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Table 4: Calculating expected price per share in 10 years with a 1% appreciation/year.

Adjusting the formula for present value of the stock price in 10 years makes:

And so the new estimate for stock value is:

With a solid company like Coca Cola a dividend stock’s price appreciation is due mostly because of diluted earnings per share increasing at a faster pace than dividends per share. This is because a company like Coca Cola rarely offers an opportunity for unprecedented growth, which could cause unnecessary price speculation. Following that logic let us assume:

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We again average the recent trend and look at earnings per share growth (2014 data is taken from Table 2):

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Table 5: Calculating average Earnings Per Share growth using 10 years historical data.

The last 10 years have had an average growth in earnings per share of 8.78%. Many reports have signaled towards a decrease in demand for carbonated drinks; however, this data correspond to a 7.78% (1%-8.78%) reduction in Coca Cola growth for the next years. There are already many articles discussing how Coca Cola is going to tackle the changing market trends; however, from a mathematical perspective it seems very unlikely that the current price of $41.57 (reflecting a 1% stock appreciation and 9.73% dividend growth) is accurate. To make a price projection I will use the data output from the I Know First state of the art market prediction algorithm.

Algorithmic Analysis

I Know First utilize an advanced self-learning algorithm to analyze, model and predict the stock market. The algorithm produces a forecast with a signal and a predictability indicator. The signal is the number in the middle of the box. The predictability is the number at the bottom of the box. At the top, a specific asset is identified. This format is consistent across all predictions.

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Table 6: Example of an I Know First algorithmic heat map.

In this particular Top 10 Stocks Forecast from November 27th 2013, XOMA had the strongest 1-month signal but did not have the strongest predictability. As the asset is in a deeper green color box, this indicates that the algorithm is very bullish.

Signal

This indicator represents the predicted movement direction/trend; not a percentage or specific target price. The signal strength indicates how much the current price deviates from what the system considers an equilibrium or “fair” price. The signal strength is the absolute value of the current prediction of the system. The signal can have a positive (predicted increase), or negative (predicted decline) sign. The heat map is arranged according to the signal strength with strongest up signals at the top, while down signals are at the bottom. The table colors are indicative of the signal. Green corresponds to the positive signal and red indicates a negative signal. A deeper color means a stronger signal and a lighter color equals a weaker signal.

Analogy with a spring: The signal strength is how much the spring is stretched. The higher is the tension the more it’ll move when the spring is released.

Predictability

This measures the importance of the signal. The predictability is the historical correlation between the prediction and the actual market movement for that particular asset, which is recalculated daily. Theoretically the predictability ranges from minus one to plus one. The higher this number is the more predictable the particular asset is. If you compare predictability for different time ranges, you’ll find that the longer time ranges have higher predictability. This means that longer-range signals are more important and tend to be more accurate.

In our recent top dividend august 1st 3 months forecast review Coca Cola had a 7.36% return from the stock appreciation alone. When predicting dividend stocks, the algorithm predicts the stock price change, and not the dividend growth. Because Coca Cola is so consistent with their dividend growth, estimation can be made for the potential yield. Our most current forecast (September 5th, 2014) has a bullish signal for Coca Cola for the 1 and 3 months time horizons, and a hold position from there onwards.

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Table 7: I Know First 1 month, 3 months and 1 year prediction tables for Coca Cola from November 5th, 2014.

As can be seen the algorithm still predicts the stock has room to grow. Although our heat map signal only projects a movement direction and trend, we can use previous stock movements following the algorithmic forecast to create an estimate of stock price change projection.

Table 8: The algorithm predicts a high probability for stock price appreciation and low probability of stock price depreciation (Updated at price level $41.8). Chart Source: Google Finance

Conclusion

Coca Cola has proven time and again to be on top of the game. With an ever expanding portfolio the company is able to adjust itself to changing consumer preferences. The current stock price does not reflect accurately on the last 10 year growth of Coca Cola’s dividend yield and earnings per share growth. The price of the market reflects an earnings per share growth of only 1% during the next few years. The I Know First algorithm has a medium bullish signal for the 1 month and 3 months time horizons, supporting a growth in stock price. Moreover, if Coca Cola successfully enters other growing markets such as health drinks and energy drinks (as they have already begun doing) their stock will be significantly undervalued (do to the potential increase in earnings per share), so keep posted to upcoming news about the company. In summary, as a 10 year investment Coca Cola makes a very viable opportunity for dividend and stock price appreciation with a very low risk.

I Know First Research is the analytic branch of I Know First, a financial startup company that specializes in quantitatively predicting the stock market. This article was written by Daniel Hai, one of our interns. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.