14 21 Valuation of Coca Cola Using Market Multiples The Coca Cola Company is a global soft drink beverage company that is a direct competitor with Starbucks The data in Chapter 12, Exhibits 12 14, 12 15, and 12 16, include the actual amounts for 2015 and projected amounts for Year 1 to Year 6 for the income statements, balance sheets, and statements of cash flows for Coca Cola The market equity beta for Coca Cola at the end of 2015 is 0 75 Assume that the risk free interest rate is 3 0 and the market risk premium is 6 0 Coca Cola has 4,324 million shares outstanding at the end of 2015, when Coca Colas share price was $42 96 Required Part IComputing Coca Colas Value to Book Ratio Using the Value to Book Valuation Approach Use the CAPM to compute the required rate of return on common equity capital for Coca Cola Using the projected financial statements in Exhibits 12 14, 12 15, and 12 16, derive the projected residual ROCE (return on common shareholders equity) for Coca Cola for Years 1 through 5 The projected income statements and balance sheets for Year 6 assume Coca Cola will grow at a steady state growth rate of 3 0 Derive the projected residual ROCE for Year 6 for Coca Cola Using the required rate of return on common equity from Requirement a as a discount rate, compute the sum of the present value of residual ROCE for Coca Cola for Years 1 through 5 Using the required rate of return on common equity from Requirement a as a discount rate and the long run growth rate from Requirement c, compute the continuing value of Coca Cola as of the start of Year 6 based on Coca Colas continuing residual ROCE in Year 6 and beyond After computing continuing value as of the start of Year 6, discount it to present value at the start of Year 1 Compute Coca Colas value to book ratio as of the end of 2015 with the following three steps (1) Compute the total sum of the present value of all future residual ROCE (from Requirements d and e) (2) To the total from Requirement f(1), add 1 (representing the book value of equity as of the beginning of the valuation as of the end of 2015) (3) Adjust the total sum from Requirement f(2) using the midyear discounting adjustment factor Compute Coca Colas market to book ratio as of the end of 2015 Compare the value to book ratio to the market to book ratio What investment decision does the comparison suggest What does the comparison suggest regarding the pricing of Coca Cola shares in the market underpriced, overpriced, or fairly priced Use the value to book ratio to project the value of a share of common equity in Coca Cola If you computed Coca Colas common equity share value using the free cash flows to common equity valuation approach in Problem 12 16 in Chapter 12 and or the residual income valuation approach in Problem 13 19 in Chapter 13, compare the value estimate you obtained in those problems with the estimate you obtained in this case You should obtain the same value estimates under all three approaches If you have not yet worked those problems, you would benefit from doing so now Part IIAnalyzing Coca Colas Share Price Using the Value Earnings Ratio, Price Earnings Ratio, and Reverse Engineering j Use the forecast data for Year 1 to project Year 1 earnings per share To do so, divide the projection of Coca Colas comprehensive income available for common shareholders in Year 1 by the number of common shares outstanding at the end of 2015 Using this Year 1 earnings per share forecast and the share value computed in Requirement h, compute Coca Colas value earnings ratio k Using the Year 1 earnings per share forecast from Requirement j and using the share price at the end of 2015, compute Coca Colas price earnings ratio Compare Coca Colas value earnings ratio with its price earnings ratio What investment decision does the comparison suggest What does the comparison suggest regarding the pricing of Coca Cola shares in the market underpriced, overpriced, or fairly priced Does this comparison lead to the same conclusions you reached when comparing value to book ratios with market to book ratios in Requirement g l Reverse engineer Coca Colas share price at the end of 2015 to solve for the implied expected rate of return First, assume that value equals price and that the earnings and 3 long run growth forecasts through Year 6 and beyond are reliable proxies for the markets expectations for Coca Cola Then solve for the implied expected rate of return (the discount rate) the market has impounded in Coca Colas share price (Hint Begin with the forecast and valuation spreadsheet you developed to value Coca Cola shares Vary the discount rate until you solve for the discount rate that makes your value estimate exactly equal the end of 2015 market price of $42 96 per share ) m Reverse engineer Coca Colas share price at the end of 2015 to solve for the implied expected long run growth First, assume that value equals price and that the earnings forecasts through Year 5 are reliable proxies for the markets expectations for Coca Cola Also assume that the discount rate implied by the CAPM (computed in Requirement a) is a reliable proxy for the markets expected rate of return Then solve for the implied expected long run growth rate the market has impounded in Coca Colas share price Hint Begin with the forecast and valuation spreadsheet you developed to value Coca Cola shares and use the CAPM discount rate Set the long run growth parameter initially to zero Increase the long run growth rate until you solve for the growth rate that makes your value estimate exactly equal the end of 2015 market price of $42 96 per share Exhibit 12 16 The Coca Cola Company Projected Implied Statements of Cash Flows for Year 1 through Year 6 (amounts in millions allow for rounding) (Problem 12 16) Forecasts Year 3 Year 4 Year 1 Year 2 Year 5 Year 6 $ 7,607 2,032 (131) $ 7,835 2,242 (135) (96) (88) $ 8,071 2,459 (139) $ 8,315 2,681 (143) (102) (93) $8,564 631 (148) (105) (96) 193) 199) (85) (90) $ 7,374 1,829 (434) (208) (83) 3,900 (797) 206 118 (1,133) (16) 67 47 212 218 16 225 65 232 16 239 16 16 0 0 0 165 164 163 160 150 129 133 145 Net Income Add back depreciation expense (net) Decrease in receivables net Decrease in inventories Decrease in prepaid expenses Decrease in other current assets Increase in accounts payable trade Increase in current accrued liabilities Increase in other current liabilities Net change in deferred tax assets and liabilities Increase Decrease in property, plant, equip at cost Decrease in marketable securities Decrease in investment securities Decrease in amortizable intangible assets (net) Decrease in goodwill and nonamort intangibles Decrease in other noncurrent assets Net Cash Flows from Investing Activities Increase Decrease in receivables net Decrease in inventories Decrease in prepaid expenses Decrease in other current assets Increase in accounts payable trade Increase in current accrued liabilities Increase in other current liabilities Net change in deferred tax assets and liabilities Increase Decrease in property, plant, equip at cost Decrease in marketable securities Decrease in investment securities Decrease in amortizable intangible assets (net) Decrease in goodwill and nonamort intangibles Decrease in other noncurrent assets Net Cash Flows from Investing Activities Increase

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14.21 Valuation of Coca-Cola Using Market Multiples. The Coca-Cola Company is a global soft-drink beverage company that is a direct competitor with Starbucks . The

14.21 Valuation of Coca-Cola Using Market Multiples. The Coca-Cola Company is a global soft-drink beverage company that is a direct competitor with Starbucks. The data in Chapter 12, Exhibits 12.14, 12.15, and 12.16, include the actual amounts for 2015 and projected amounts for Year +1 to Year +6 for the income statements, balance sheets, and statements of cash flows for Coca-Cola.

The market equity beta for Coca-Cola at the end of 2015 is 0.75. Assume that the risk-free interest rate is 3.0% and the market risk premium is 6.0%. Coca-Cola has 4,324 million shares outstanding at the end of 2015, when Coca-Colas share price was $42.96.

Required

Part IComputing Coca-Colas Value-to-Book Ratio Using the Value-to-Book Valuation Approach

Use the CAPM to compute the required rate of return on common equity capital for Coca-Cola.
Using the projected financial statements in Exhibits 12.14, 12.15, and 12.16, derive the projected residual ROCE (return on common shareholders equity) for Coca-Cola for Years +1 through +5.
The projected income statements and balance sheets for Year +6 assume Coca-Cola will grow at a steady-state growth rate of 3.0%. Derive the projected residual ROCE for Year +6 for Coca-Cola.
Using the required rate of return on common equity from Requirement a as a discount rate, compute the sum of the present value of residual ROCE for Coca-Cola for Years +1 through +5.
Using the required rate of return on common equity from Requirement a as a discount rate and the long-run growth rate from Requirement c, compute the continuing value of Coca-Cola as of the start of Year +6 based on Coca-Colas continuing residual ROCE in Year +6 and beyond. After computing continuing value as of the start of Year +6, discount it to present value at the start of Year +1.
Compute Coca-Colas value-to-book ratio as of the end of 2015 with the following three steps:
- (1)
  Compute the total sum of the present value of all future residual ROCE (from Requirements d and e).
- (2)
  To the total from Requirement f(1), add 1 (representing the book value of equity as of the beginning of the valuation as of the end of 2015).
- (3)
  Adjust the total sum from Requirement f(2) using the midyear discounting adjustment factor.
Compute Coca-Colas market-to-book ratio as of the end of 2015. Compare the value-to-book ratio to the market-to-book ratio. What investment decision does the comparison suggest? What does the comparison suggest regarding the pricing of Coca-Cola shares in the market: underpriced, overpriced, or fairly priced?
Use the value-to-book ratio to project the value of a share of common equity in Coca-Cola.
If you computed Coca-Colas common equity share value using the free cash flows to common equity valuation approach in Problem 12.16 in Chapter 12 and/or the residual income valuation approach in Problem 13.19 in Chapter 13, compare the value estimate you obtained in those problems with the estimate you obtained in this case. You should obtain the same value estimates under all three approaches. If you have not yet worked those problems, you would benefit from doing so now.

Part IIAnalyzing Coca-Colas Share Price Using the Value-Earnings Ratio, Price-Earnings Ratio, and Reverse Engineering

j.
Use the forecast data for Year +1 to project Year +1 earnings per share. To do so, divide the projection of Coca-Colas comprehensive income available for common shareholders in Year +1 by the number of common shares outstanding at the end of 2015. Using this Year +1 earnings-per-share forecast and the share value computed in Requirement h, compute Coca-Colas value-earnings ratio.
k.
Using the Year +1 earnings-per-share forecast from Requirement j and using the share price at the end of 2015, compute Coca-Colas price-earnings ratio. Compare Coca-Colas value-earnings ratio with its price-earnings ratio. What investment decision does the comparison suggest? What does the comparison suggest regarding the pricing of Coca-Cola shares in the market: underpriced, overpriced, or fairly priced? Does this comparison lead to the same conclusions you reached when comparing value-to-book ratios with market-to-book ratios in Requirement g?
l.
Reverse engineer Coca-Colas share price at the end of 2015 to solve for the implied expected rate of return. First, assume that value equals price and that the earnings and 3% long-run growth forecasts through Year +6 and beyond are reliable proxies for the markets expectations for Coca-Cola. Then solve for the implied expected rate of return (the discount rate) the market has impounded in Coca-Colas share price. (Hint: Begin with the forecast and valuation spreadsheet you developed to value Coca-Cola shares. Vary the discount rate until you solve for the discount rate that makes your value estimate exactly equal the end-of-2015 market price of $42.96 per share.)
m.
Reverse engineer Coca-Colas share price at the end of 2015 to solve for the implied expected long-run growth. First, assume that value equals price and that the earnings forecasts through Year +5 are reliable proxies for the markets expectations for Coca-Cola. Also assume that the discount rate implied by the CAPM (computed in Requirement a) is a reliable proxy for the markets expected rate of return. Then solve for the implied expected long-run growth rate the market has impounded in Coca-Colas share price. [Hint: Begin with the forecast and valuation spreadsheet you developed to value Coca-Cola shares and use the CAPM discount rate. Set the long-run growth parameter initially to zero. Increase the long-run growth rate until you solve for the growth rate that makes your value estimate exactly equal the end-of-2015 market price of $42.96 per share.]

Exhibit 12.16 The Coca-Cola Company Projected Implied Statements of Cash Flows for Year +1 through Year +6 (amounts in millions; allow for rounding) (Problem 12.16) Forecasts Year +3 Year +4 Year +1 Year +2 Year +5 Year +6 $ 7,607 2,032 (131) $ 7,835 2,242 (135) (96) (88) $ 8,071 2,459 (139) $ 8,315 2,681 (143) (102) (93) $8,564 631 (148) (105) (96) 193) 199) (85) (90) $ 7,374 1,829 (434) (208) (83) 3,900 (797) 206 118 (1,133) (16) 67 47 212 218 16 225 65 232 16 239 16 16 0 0 0 165 164 163 160 150 129 133 145 Net Income Add back depreciation expense (net) Decrease in receivables-net Decrease in inventories Decrease in prepaid expenses Decrease in other current assets Increase in accounts payable-trade Increase in current accrued liabilities Increase in other current liabilities Net change in deferred tax assets and liabilities Increase Decrease in property, plant, & equip. at cost Decrease in marketable securities Decrease in investment securities Decrease in amortizable intangible assets (net) Decrease in goodwill and nonamort. intangibles Decrease in other noncurrent assets Net Cash Flows from Investing Activities Increase Decrease in receivables-net Decrease in inventories Decrease in prepaid expenses Decrease in other current assets Increase in accounts payable-trade Increase in current accrued liabilities Increase in other current liabilities Net change in deferred tax assets and liabilities Increase Decrease in property, plant, & equip. at cost Decrease in marketable securities Decrease in investment securities Decrease in amortizable intangible assets (net) Decrease in goodwill and nonamort. intangibles Decrease in other noncurrent assets Net Cash Flows from Investing Activities Increase