Dividend discount model with supernormal growth

International Research Journal of Applied Finance ISSN 2229 – 6891 Vol. VII Issue – 3 March, 2016 Case Study Series

P a

g e 1

Using the Dividend Discount Model in Valuation: The Case of PepsiCo

Halil D. Kaya* Julia S. Kwok

Abstract This case is an application of a valuation method, the dividend discount model, for PepsiCo. In this case, students will learn how to use a company’s dividend estimates in the coming years to estimate its share value. Students will first discuss the three possible scenarios for dividend growth: the zero-growth model, the constant growth model, and the supernormal growth model. They will discuss each model’s advantages and disadvantages. Then, they will proceed with their valuation using the assumptions given in the case. PepsiCo’s most recent financial statements are provided in the case for students’ use. After estimating the company’s share value, students will compare it to the company’s current share price to reach an investment decision. It is a real- world application for students who want to learn how to use dividends in valuation. Keywords: financial statement analysis, valuation, dividend discount model, Pepsi, PepsiCo JEL classifications: L25, G11, G12, G15, F23 Introduction John was a newly hired security analyst of AJJ Minnesota Investment Company. His job was to evaluate financial securities based on asset pricing models and fundamental analysis. He worked with portfolio managers to support their buy, hold or sell decisions on financial securities. It was 2:30 p.m. in the afternoon; John really needed some boost after the long meeting with his clients. Headed towards the staff’s lounge, he was looking forward to grab his favorite Coca Cola. To his disappointment, he found the whole refrigerator was filled with low calories, healthy drinks. As he pushed through those low sodium V8, Naked Juice, Gatorade and La Croix Sparkling Water with natural flavors, he managed to find a can of Pepsi Cola at the back of the rack. Fierce Competition While John was indulging in his favorite Doritos, his Pepsi rival, Mary Ann, walked in. Mary Ann was a senior security analyst, and she was a devoted Pepsi fan. “Hi Polar bear, I am glad that you finally take the Pepsi Challenge! Be young, have fun and drink Pepsi,” said Mary Ann. John replied, “Nothing can beat the real thing.” “The decade old cola war has a new front. Those healthy products, that are occupying our fridge right now, are pushing down the demand for carbonated soft drinks. It went from 46 to 38 gallons per capita in the past 10 years. May be it’s time to re-evaluate your Pepsi stocks,” John added (StreetAuthority 2014). John continued: “Have you noticed the sudden increase in PepsiCo’s shares from February to November 2014? It jumped from a low of $78.09 on February 10, 2014 to $100.10 on November 24, 2014. When I checked Coke’s shares for the same period, I noticed that there was only a 7% increase in Coke shares. It was $88.42 on March 9 and later it went up to only $94.56 on November 24. The S&P500 ETF went up by only 10%, from 188.26 to 207.20”.

International Research Journal of Applied Finance ISSN 2229 – 6891 Vol. VII Issue – 2 February, 2016 Case Study Series

P a

g e 2

“Pepsi is a much bigger company, with more than twice as many employees as Coke globally. Even though the predicted soft drink consumption per capita going down each year, I am glad that soda is only 25% of Pepsi’s US sales,” Mary Ann exclaimed (Flanagan 2013). “Moreover, Pepsi has the edge of understanding the changing consumer taste. The new CEO has Pepsi refocused on water, tea, juice and sports drinks as well as Quaker Oats and Gatorade. I think Pepsi will continue to have its 6% growth rate (StreetAuthority 2014). “Numbers don’t lie. Let us take a look at the value of Pepsi’s stock and compared to its price,” John suggested. “John, my portfolio holds quite a bit of Pepsi stocks, our discussion made me a bit nervous about my investment. Let us run some valuation models to figure out whether it is a good time to buy, sell or hold those Pepsi stocks. Both of us may be able to make some money if we find any significant discrepancy between the current selling price and the stock’s intrinsic value,” Mary Ann answered. Financial Analysis The surprising increase of stock price of Pepsi compared to the growth of its competitors and the market triggered the curiosity of these two analysts. They would be able to take advantage of the rise of stock price if the market value of the stock greatly diverted from intrinsic value. A buy, hold or sell decision can be made based on the comparison. In order to compare the market price with the intrinsic value, John had to find the current stock price. He looked up PepsiCo, Inc.’s stock price as of 12/31/2013 from the internet. It was $82.94 (nasdaq.com/symbol/pep/historical). The next step was to find out what evaluation models can be used to find the intrinsic value of the stock. “Two well-known methods for the valuation of stocks are dividend discount model and the residual earning models. Since Pepsi is a publicly traded stock paying dividends each year, it will not be difficult to obtain the dividends and earnings data from their financial statement,” said Mary Ann. She suggested using both methods to come up with the investment decision of buy, hold or sell because each of the methods had their limitations and drawbacks. Dividend Discount Model To start, John would like to focus on gathering data for the dividend discount model first. From Pepsi’s income statement from 2008 to 2013 (Exhibit 1), John was able to collect dividends per share data from 2008 to 2013 (www.nasdaq.com/symbol/pep/dividend-history).

2008 2009 2010 2011 2012 2013

$1.65 $1.78 $1.89 $2.03 $2.13 $2.24

“In addition to dividends, what else do we need?” John asked. “We will need to know the growth rate of the dividends as well as the discount rate to discount the dividends. Moreover, the growth rate in the future may change. Let’s try to use the annual growth rate of dividends in 2008-2013 to predict the growth for the next four years (2013-2017). John, can you verify for me to see if the growth rate is 6.3048%? With the new CEO, I would expect only a slight

International Research Journal of Applied Finance ISSN 2229 – 6891 Vol. VII Issue – 2 February, 2016 Case Study Series

P a

g e 3

decrease of growth rate. Let’s assume a 6% growth rate after the fourth year and it will be the growth rate forever” Mary Ann answered. “Yes, Madam,” John added, “I know how to find the discount rate to discount those dividends. The discount rate should be the cost of common stock, right?” John got excited and continued, “I remember the constant growth model says r= (D1/P)+g where D1 will be the dividend in 2014.” “But for the dividend discount model, should I use the zero growth, constant growth or supernormal growth assumptions? How does the growth assumption impact the price valuation?” John puzzled. “Well, may be, we can run all those models to see the impact of the growth rate on the price. Logically, the value of the stock is going to have higher when there is more growth because the intrinsic value is based on the present value of future dividends,” Mary Ann explained. “Our investment decision will be based on the comparison of the intrinsic value and the current market price. We may come up with different trading strategies with different assumptions,” Mary Ann continued. John agreed. So John pulled the formula for those three models:

1. Zero-growth: P = D/r Where P is the value estimate, D is the current dividend amount, and r is the cost of common stock (or the required return by the shareholders).

2. The constant-growth: P = D1/(r-g)

Where P is the value estimate, D0 is the current dividend amount, D1 is the estimated dividend in year 1, r is the cost of common stock (or the required return by the shareholders), and g is the constant growth rate.

3. Supernormal growth model: P = (D0*(1+g1))/(1+r) + (D0*(1+g1) 2 )/(1+r)

2 + CV/(1+r)

2

Where CV = Continuing Value = (D0*(1+g1)

2 *(1+g2))/(r-g2)

P = the value estimate, D0 is the current (most recent) dividend amount, r is the cost of common stock (or the required return by the shareholders), g1 is the initial growth rate, and g2 is the second growth rate.

“Are we ready to start now?” Mary Ann asked. “Wow, thank you so much for your insights. I look forward to run some numbers and see if we can make any money out of all this. However, before we get to get busy working on these two models and three growth assumptions, I want to get enjoy the rest of my Cola and Doritos,” John replied with a smile. “I hope Pepsi will still be the choice of a new generation!” Mary Ann exclaimed. The two colleagues went to lunch and then worked on their computers for a while. After two hours, Mary Ann visited John in his office. She said with a smiling face: “I think, in order to value the company’s shares, we will need to answer the following questions:

International Research Journal of Applied Finance ISSN 2229 – 6891 Vol. VII Issue – 2 February, 2016 Case Study Series

P a

g e 4

1. What is the purpose of the dividend discount model? 2. What are the advantages and the disadvantages of the method?

3. What are the zero-growth, the constant-growth, and the supernormal growth models

under the dividend discount model? How do we proceed with each of them?

4. Which model would give a higher estimated value: the zero-growth model or the

constant-growth model? With which model would we have a higher chance of giving a

“buy” recommendation for the stock?

5. Estimate the annual growth rate in PepsiCo’s dividends over the 2008-2013 period using

the data given in the case. Calculate both the arithmetic average and the geometric

average annual growth rates in PepsiCo’s dividends over the period, and then take the

average of those two measures as your best estimate for PepsiCo’s expected growth over

the next 4 years (i.e. 2014-2017)

6. What are the ways to estimate the cost of common stock (i.e. or the required return on

common stock)? We can use the dividend growth model formula P=D1/(r-g) to estimate

the cost of common stock (r). We know PepsiCo’s actual closing stock price on

12/31/2013. For g, we can use the number that we will find in question #5. For D1, again

we can use the growth number that we will find in #5.

7. Estimate the value of PepsiCo shares using the following models:

The zero-growth model The constant-growth model The supernormal growth model

8. Based on each model, what would be our investment advice for potential investors in PepsiCo shares?

9. If we want to go ahead with the supernormal growth model, what would be our decision? Is the stock a good buy?” Mary Ann concluded.

John was excited: “Wow, you are so organized! Now, I think these questions will better guide us through this process. Let’s get to work then!”

International Research Journal of Applied Finance ISSN 2229 – 6891 Vol. VII Issue – 2 February, 2016 Case Study Series

P a

g e 5

Exhibit 1- Pepsico’s Annual Income Statements

Consolidated St. of Income (USD $) In Millions, except Per Share data, unless

otherwise specified

12 Months Ended

Dec. 28, 2013 Dec. 29, 2012 Dec. 31, 2011

Income Statement [Abstract]

Net Revenue $ 66,415

$ 65,492

$ 66,504

Cost of sales 31,243

31,291

31,593

Selling, general and administrative expenses 25,357

24,970

25,145

Amortization of intangible assets 110

119

133

Operating Profit 9,705 [1]

9,112 [1]

9,633 [1]

Interest expense (911)

(899)

(856)

Interest income and other 97

91

57

Income before income taxes 8,891

8,304

8,834

Provision for income taxes 2,104

2,090

2,372

Net income 6,787

6,214

6,462

Less: Net income attributable to noncontrolling interests

47

36

19

Net Income Attributable to PepsiCo $ 6,740

$ 6,178

$ 6,443

Net Income Attributable to PepsiCo per Common Share

Basic $ 4.37

$ 3.96

$ 4.08

Diluted $ 4.32

$ 3.92

$ 4.03

Weighted-average common shares outstanding

Basic 1,541 [2]

1,557 [2]

1,576 [2]

Diluted 1,560 [2]

1,575 [2]

1,597 [2]

Cash dividends declared per common share $ 2.24

$ 2.1275

$ 2.025

[1] For information on the impact of restructuring, impairment and integration charges on our divisions, see Note 3 to our consolidated financial statements. See also Note 15 to our consolidated financial statements for more information on our transaction with Tingyi and refranchising of our beverage business in Vietnam in our AMEA segment.

[2] Weighted-average common shares outstanding (in millions).

International Research Journal of Applied Finance ISSN 2229 – 6891 Vol. VII Issue – 2 February, 2016 Case Study Series

P a

g e 6

Exhibit 1 (continued)

Consolidated Statement of Income (USD $) In Millions, except Per Share data

12 Months Ended

Dec. 25, 2010 Dec. 26, 2009 Dec. 27, 2008

Net Revenue $ 57,838 [1]

$ 43,232 [1]

$ 43,251 [1]

Cost of sales 26,575

20,099

20,351

Selling, general and administrative expenses 22,814

15,026

15,877

Amortization of intangible assets 117

63

64

Operating Profit 8,332 [2]

8,044 [2]

6,959 [2]

Bottling equity income 735

365

374

Interest expense (903)

(397)

(329)

Interest income 68

67

41

Income before income taxes 8,232

8,079

7,045

Provision for income taxes 1,894

2,100

1,879

Net income 6,338

5,979

5,166

Less: Net income attributable to noncontrolling interests

18

33

24

Net Income Attributable to PepsiCo $ 6,320

$ 5,946

$ 5,142

Net Income Attributable to PepsiCo per Common Share

Basic $ 3.97

$ 3.81

$ 3.26

Diluted $ 3.91

$ 3.77

$ 3.21

Cash dividends declared per common share $ 1.89

$ 1.775

$ 1.65

[1] Represents net revenue from businesses operating in these countries.

[2] For information on the impact of restructuring, impairment and integration charges on our divisions, see Note 3.

Source: nasdaq.com/symbol/pep/sec-filings

International Research Journal of Applied Finance ISSN 2229 – 6891 Vol. VII Issue – 2 February, 2016 Case Study Series

P a

g e 7

References Flanagan, Peter Soft Drinks take a healthy beating but remain prized brands (August 14, 2013). Retrieved October 1, 2015 from http://www.independent.ie/business/world/soft-drinks-take-a-healthy-beating-but-remain-prized- brands-29497092.html

PepsiCo, Inc.’s Dividend History (2008-2013). Retrieved September 13, 2015 from http://www.nasdaq.com/symbol/pep/dividend-history

PepsiCo, Inc.’s EPS (2004-2013). Retrieved September 15, 2015 from http://www.nasdaq.com/symbol/pep/revenue-eps

Pépsico, Inc.’s SEC Filings (2008-2013). Retrieved September 11, 2015 from http://www.nasdaq.com/symbol/pep/sec-filings

Pepsi Co.’s Stock Price (2013). Retrieved September 15, 2015 from http://www.nasdaq.com/symbol/pep/historical

StreetAuthority Coke Vs. Pepsi: By the Numbers (March 24, 2014). Retrieved September 18, 2015 from http://www.nasdaq.com/article/coke-vs-pepsi-by-the-numbers-cm337909 Authors Halil D. Kaya* Associate Professor of Finance, Department of Accounting and Finance, College of Business and Technology, Northeastern State University, Broken Arrow, OK 74014; kaya@nsuok.edu Julia S. Kwok Associate Professor of Finance, Department of Accounting and Finance, College of Business and Technology, Northeastern State University, Broken Arrow, OK 74014 *Corresponding author