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Is PepsiCo Overvalued Today?

- By Ben Reynolds

There are many different ways investors can value stocks when looking for possible investments. Perhaps the most popular way is dividing the current share price by the company's earnings per share to get the price-earnings multiple. For real estate investment trusts, price to funds from operations is used. Others use price to cash flow or price to sales to help determine the valuation of an investment.


Dividend growth investors often use the dividend discount model when valuing stocks. The dividend discount model estimates fair value for a stock using the expected growth rate, current dividend and a reasonable discount rate. Iconic dividend growth stock PepsiCo Inc. (PEP) is a good candidate for valuation using the dividend discount model.

Company background

Pepsi produces, markets and sells its food and beverage products around the world. The company generated $63 billion in sales last year. While many consumers know the company for its carbonated beverages, like Pepsi and Mount Dew, food and snacks actually contribute more than 50% of sales. In total, Pepsi has 23 $1 billion brands, including Pepsi, Gatorade, Lipton and Lay's and Doritos chips.

The current trend among consumers is to eat and drink items with less sugar and fewer calories. Several packaged food companies have seen their top and bottom lines suffer as a result, but not Pepsi. For these consumers, Pepsi offers a line of products that they call "Better For You." Almost half of sales come from products with less than 70 calories from added sugar. At a time when consumers are being more cognizant about what they consume, Pepsi offers innovative products that appeal to customers of all types.

Second-quarter earnings results

Pepsi reported second-quarter earnings on July 10. Earnings per share grew 7.3% to $1.61. This was 9 cents higher than the average analysts' estimate. Revenue grew 2.4% from the prior-year quarter to $16.1 billion. Revenue results topped expectations by $50 million.

Pepsi had 2.6% organic growth across its businesses, a slight improvement from the first quarter's 2.3% organic growth. This is fairly robust organic growth for a mature consumer staples company, especially at a time when many companies in this sector are seeing declining revenues. Frito-Lay North America, Pepsi's second-largest segment, grew revenues 4%.

For North American Beverage, Pepsi's largest division, sales were down 1% year over year. Carbonated beverages have been a drag on most companies in this space as consumers in North America have become more conscious about what they eat and drink. Still, this 1% drop was better than the 6% sales decline in prior quarters.

Sales by geography were somewhat mixed. FLNA saw volumes grow 2%, while NAB's volume declined 2%. Latin America saw a 1% increase in revenues while Europe Sub Saharan Africa posted 11% growth. ESSA saw food volumes rise 3.5% and beverage volumes increase 8%, leading to organic growth of 7%.

Wrapping up results, Quaker Foods North America saw a 5% decline in revenue. Much of this decline was due to promotional spending on products. Higher commodity costs also had an impact on this division. The segment only accounted for roughly 3% of total quarterly revenues.

Pepsi's effective tax rate for the quarter was 21%, down slightly from the 23.5% effective tax rate in the second quarter of last year. The company also reaffirmed its guidance for the year for earnings per share ($5.70), cash from operations ($9 billion) and free cash flow ($6 billion).

These high levels of cash are important as they will fund Pepsi's dividend going forward. Pepsi has one of the longest dividend growth streaks in the market.

Dividend history and valuation for Pepsi

Pepsi has increased its dividend for the past 46 years, making the company a Dividend Aristocrat. Even after this lengthy dividend streak, the company still offers high single-digit dividend growth. The company has grown its dividend at:

  • 7.7% annually over the last three years.

  • 8.5% annually over the last five years.

  • 8.9% annually over the last 10 years.



While the dividend growth has slowed slightly in recent years, Pepsi did increase its dividend payment by 15.2% this past June. Shares currently yield 3.21%, well above the yield of the S&P 500 (1.76%) and slightly above the yield of 10-Year Treasury Bond (2.99%).

Consumer staple stocks often lack enough growth for investors, so to entice investors to purchase shares, they can have very generous dividend yields. This requires these companies to have a high payout ratio. Pepsi, on the other hand, has a very reasonable payout ratio. Over the past decade, the company's average payout ratio is just 54%. Based off of expected dividends and earnings per share for 2018, the company's payout ratio is 63%. This is higher than the average, but still leaves plenty of room to offer future increases. The last 46 years have covered several different economic cycles and Pepsi has managed to increase its dividend every year. It is likely that the company would continue to increase its dividend even if earnings were to suffer a drastic decline.

How do Pepsi shares fair when using the dividend discount model? Using Pepsi's 10-year average growth rate of 4%, current dividend of $3.71 and a discount rate of 8.4%, the dividend discount model estimates fair value for the stock to be $86.90. Based on Monday's closing price of $115.40, shares are currently almost 25% overvalued. Shares have declined nearly 4% in 2018, but are up 10% since the beginning of 2017.

It is worth noting this model isn't the only valuation system that sees shares of Pepsi as overvalued. Pepsi's current price-earnings multiple of 20.2 is above the stock's 10-year average multiple of 18.9.

Conclusion

The dividend discount model is just one way investors can value stocks. Pepsi's stock is trading at elevated levels, but this valuation is likely justified because the business has performed much better than some of its peers. Even with an impressive dividend growth streak, those who use the dividend discount model to value stocks would need a significant pullback to add shares of Pepsi to their portfolio.

Disclosure: I am not long any of the stocks mentioned in this article.

This article first appeared on GuruFocus.


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