Today, Would Warren Buffett Buy Coca-Cola or Pepsi? Part 2

So Coke and Pepsi are both Berkshire Hathaway type companies. Now lets review some numbers.

Are Earnings Predictable? Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Annual earnings per share for Coca Cola, KO NYSE, for the last ten years from earliest to most recent were 1.42 in 1997 and have steadily increased to 2.57 in 2007. Buffett would consider KO's earnings predictable, although earnings have declined 2 times in the past seven years, with the most recent decline 8 years ago. The dips have totaled 41.2%. Coke's long term historical EPS growth rate is 4.6%, based on the 10 year average EPS growth rate.

For Pepsi, PEP NYSE - Annual earnings per share from earliest to most recent were 1.31 in 1997,increasing to 3.41 in 1997. Buffett would consider pepsi's earnings predictable, although earnings have declined 2 times in the past seven years, with the most recent decline 3 years ago. The dips have totaled 7.2%. Pepsi's long term historical EPS growth rate is 13.6%, based on the 10 year average EPS growth rate, and it is expected to grow earnings 11.0% per year in the future, based on the analysts' consensus estimated long term growth rate. For the purposes of our analysis, we will use the more conservative of the two EPS growth numbers.

Advantage - Pepsi

ABILITY TO PAY OFF DEBT Buffett likes companies that are conservatively financed. Nonetheless, he has invested in companies with large financing divisions and in firms with rather high levels of debt. KO has a debt of 2,874.0 million and earnings of 5,787.2 million, which could be used to pay off the debt in less than two years, which is considered exceptional. PEP has a debt of 6,053.0 million and earnings of 5,754.8 million, which could be used to pay off the debt in less than two years, which is considered exceptional.

Advantage - Tie

Is There A CONSISTENTLY HIGHER THAN AVERAGE RETURN ON EQUITY? Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for KO, over the last ten years, is 30.6%, which is high enough to pass. It is not enough that the average be at least 15%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROE must be at least 10% for Buffett to feel comfortable that the ROE is consistent. In addition, the average ROE over the last 3 years must also exceed 15%. The coca cola ROE averages over the last 3 years is 28.8%, thus passing this criterion.

The average ROE for PEP, over the last ten years, is 30.3%, which is high enough to pass.

Advantage - Pepsi

Is There A CONSISTENTLY HIGHER THAN AVERAGE RETURN ON TOTAL CAPITAL? Because some companies can be financed with debt that is many times their equity, they can show a consistently high ROE, yet still be in unattractive price competitive businesses. To screen this out, for non-financial companies Buffett also requires that the average Return On Total Capital ROTC- be at least 12% and consistent. In addition, the average ROTC over the last 3 years must also exceed 12%. Return On Total Capital is defined as the net earnings of the business divided by the total capital in the business, both equity and debt. The average ROTC for KO, over the last ten years, is 27.5% and the average ROTC over the past 3 years is 26.3%, which is high enough to pass.

The average ROTC for PEP, over the last ten years, is 23.9% and the average ROTC over the past 3 years is 26.7%, which is high enough to pass.

Results - a tie

CAPITAL EXPENDITURES: Buffett likes companies that do not have major capital expenditures. That is, he looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive. KO's free cash flow per share of $1.01 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion. PEP's free cash flow per share of $1.39 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion. Advantage - Pepsi

MANAGEMENT'S USE OF RETAINED EARNINGS: Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $7.75 and compares it to the gain in EPS over the same period of $1.15. KO's management has proven it can earn shareholders a 14.8% return on the earnings they kept. This return is acceptable to Buffett, but he would prefer to see a return greater than 15%. Essentially, management is doing a good job putting the retained earnings to work.

For Pepsi, the total amount of retained earnings over the previous ten years of $13.01 and compares it to the gain in EPS over the same period of $2.10. PEP's management has proven it can earn shareholders a 16.1% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work. Advantage - Pepsi

So far, pepsi is winning

Click here to read Part 1

About the Author
Dr. Barry Lycka is president of http://www.lesTout.com , the worlds number one source for online guidance.

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