DCF Valuation and EVA & MVA Assignment –
The Coca Cola Company
I. Introduction
Some of the valuation measures used by investors to analyze whether or not it is beneficial to invest in a company are the Discounted Cash Flow (DCF) Valuation, the Economic Value Added (EVA) and Market Value Added (MVA) Analysis. The Coca Cola Company (KO) has been one of the leading bottled beverage producers for decades but has been facing declining sales due to a more health-conscious consumer market in the most recent years. These declining sales and increased interest expenses due to increased liabilities after a majority acquisition of shares in Green Mountain Beverage Co. resulted only in acceptable, but not too promising future financial performance forecasts for KO in the eVal Model. This paper will analyze whether KO is still a good investment choice through a DCF Valuation and whether the company is able to create shareholder wealth or destroys it through an EVA and MVA analysis.
II. Explanation of the Variables Used in the DCF Valuation
The Discounted Cash Flow (DCF) Valuation analyzes future cash flow estimates and discounts these with a discount rate to create a present value for the predicted future cash flows. The DCF valuation evaluates the potential for investment. If the value of the DCF valuation is greater than the cost of the investment it is considered a good stock pick (Damodaran, n.d.).
The variables used in the DCF valuation include: Cost of Equity (calculated with the CAPM) and Cost of Net Debt (based on KO’s SEC 10K), which result in the Weighted Average Cost of Capital (WACC) that will be used as the discount rate in the DCF valuation. KO does not have any preferred stock outstanding; thus the value is 0% in this model. Furthermore, the terminal growth rate is important in the DCF valuation to determine the future cash flow estimates.
The Coca Cola Company has a Cost of Common Equity of 6%. The input for the CAPM formula are the risk-free rate of 1.76% based on the rate of the 10-year treasury bond as of 2/19/15 (Yahoo! Finance, 2016), the market risk premium, which is according to average historic rates 5.5% and the beta coefficient of KO of 0.77 (Yahoo! Finance, 2016). The Cost of Equity was calculated with the CAPM Formula:
Cost of Equity = Risk-free Rate + Market Risk Premium * Beta of KO
= 1.76% + 5.5% * 0.77
= 5.995% or approximately 6%.
The Cost of Debt is based on interest rates on short- and long-term debt stated in the company’s SEC 10K. According to KO’s SEC 10K, the company’s average cost of debt for short-term debt is 1.2% and the average cost for long-term debt is 2.2% (Coca Cola, 2015). Weighted by the amount of short- and long-term debt outstanding this results in an average cost of debt of 1.65%. However, entering a value lower than 4% into the eVal Model led to invalid results, thus the cost of debt for the purpose of this analysis was entered as 4% in the eVal Model, the lowest valid cost of debt. KO has a corporate tax rate of 23.60% according to the company’s SEC 10K (Coca Cola, 2015).
Based on these inputs, the adjusted WACC is 9.73%. WACC is calculated with the following formula:
WACC = (weight of equity * cost of equity) + (weight of debt * cost of debt) * (1-tax rate) (Clayman et al., 2012).
The last input factor needed for the DCF Valuation is the terminal growth rate, which is 3% for KO. The Coca Cola Company is a stable company and therefore does not expect large growth as a technology firm would, but marginal growth. A positive growth rate signals the company is expected to be able to improve its performance from the previous years by further diversifying its product portfolio through strategic acquisitions like the partnership with Green Mountain Beverage Company.
Entering the above presented variables in the DCF Valuation in the eVal Model led to the results discussed in the following section.
III. Explanation and Interpretation of DCF Valuation Results
The DCF Valuation in the eVal Model can be used to calculate the intrinsic value of a company and therefore determine whether shares are currently selling over- or undervalued. If the intrinsic value is larger than the current market price the shares are selling undervalued and it is a good investment. When the intrinsic value is less than the current market price, shares are overvalued and are not a recommended investment (Investopedia, 2003).
The DCF Valuation for KO results in a Forecasted Value of $196,556,842,000. Since the Value of Contingent Equity Claims is 0, the Value Attributable to Common Equity is $196,556,842,000. This aligns with the currently stated Market Cap of $190.36bn (Yahoo! Finance, 2016) considering a terminal growth rate of 3%. Dividing this value by the common shares outstanding, 4,366 million, the DCF Valuation forecasts a Price per Share of $45.03. On February 19, 2016 the current market price per share at the NYSE for KO was $43.77. This means the intrinsic value of KO calculated with the DCF Valuation is larger than the market price, which indicates that shares are currently selling undervalued. Considering a positive terminal growth rate and the shares selling at a lower price than the intrinsic value KO is a good investment choice.
IV. Explanation of the Data Used for the EVA Analysis and Interpretation of Results
The Economic Value Added (EVA) is used to measure the economic value added by management during a given year (EVA & MVA Model, n.d.).
The formula for EVA is:
EVA = Net Operating Profit After Tax – (WACC * Invested Capital).
The EVA considers Invested Capital as the sum of short- & long-term debt and shareholder equity. The Net Operating Profit is calculated by decreasing the operating income by the estimated income taxes of the company. The WACC calculation has been explained in the DCF Valuation section.
Entering KO’s 2014 values from the company’s financial statements into the EVA Model for short-term debt ($22,682,000), long-term debt ($19,063,000), common stock ($1,760,000) and Retained Earnings (63,408,000), Total Invested Capital of $109,519,000 is calculated. Data for the current price of stock ($43.77), Number of Shares Outstanding (4,366,000), EBIT ($9,808,000) and the corporate tax rate (23.6%) less taxes ($2,314,688) results in the NOPAT of $7,493,312. In the last step of the model values for the cost of short-term debt (1.2%), long-term debt (2.2%), the market risk premium (5.5%), the risk-free rate on a ten-year treasury bond (1.76%), debt to equity ratio (0.64), beta (0.77) leads to the Cost of Equity of 5.995% and thus to a WACC of 4.3%. The EVA Analysis based on these input factors is:
EVA = $7,493,312 – (4.3% * $109,519,000) = $2,644,023.60.
This means in 2014 the management of KO was able to create Economic Added Value of $2,644,023.60. Thus, the firm is creating shareholder wealth and is an attractive investment.
The EVA is an important measure to determine whether a company creates or destroys shareholder wealth. A closely related measure is the MVA (Peterson Drake, P. & Fabozzi, F., 2012). Usually if the company is managed in a way that increases the EVA, the MVA will also be higher. The MVA, also a measure of shareholder wealth creation will be analyzed in the next section.
V. Explanation of the Data Used for the MVA Analysis and Interpretation of Results
The Market Value Added (MVA) is the “difference between the market value of equity and the amount of Equity Capital [investors provided]” (EVA & MVA Model, n.d.). Therefore, MVA measures the amount of wealth a company has created over time and is considered the principal indicator of shareholder wealth creation. In the MVA Model the value of the firm equals the Market value of its debt and equity. The formula for the MVA calculation is:
MVA = (MV of Equity + MV of Debt) – Total Capital Invested
= Market Value of Firm – Total Capital Invested.
Using the same input as for the above discussed EVA Analysis, the MVA of KO is:
MVA = ($190,354,854.60 + $41,745,000) - $106,913,000 = $125,186,854.60.
KO’s MVA of $125,186,854.60 indicates the amount of wealth the firm has created over time (Peterson Drake, P. & Fabozzi, F. 2012). This result aligns with the connection mentioned above that usually an increase in EVA will also lead to a higher MVA. Considering the MVA as the principal indicator of shareholder wealth maximization, KO is an attractive opportunity for investors.
VI. Conclusion and Recommendation
Considering all three valuation measures discussed in this analysis The Coca Cola Company is a well performing firm and a recommended investment as it has an intrinsic value larger than the current market price, has an increased EVA and high MVA that both indicate that the firm is creating shareholder wealth. This proves even though Coca Cola faced declining sales in the most recent years, the company, if able to further diversify its product portfolio and provide consumers with healthier choices, will continue to be a valuable asset in an investor’s portfolio.
References
Clayman, M. & Fridson, M. & Troughton, H. (2012). Corporate finance: a Practical Approach, Second Edition. Hoboken, NJ: Wiley.
Coca Cola. (2015). SEC 10K. Retrieved from http://www.coca- colacompany.com/content/dam/journey/us/en/private/fileassets/pdf/2015/02/2014- annual-report-on-form-10-k.pdf
Damodaran, A. (n.d.) Discounted Cash Flow Valuation: Basics. Retrieved from http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/basics.pdf
EVA & MVA Model. (n.d.). Retrieved from https://learn.umuc.edu/d2l/le/125356/discussions/posts/18685425/ViewAttachment?fileId =5271294
Investopedia. (2003). Intrinsic Value Definition. Retrieved from http://www.investopedia.com/terms/i/intrinsicvalue.asp
Peterson Drake, P., & Fabozzi, F. (2012). Analysis of financial statements, Third Edition. Hoboken, NJ: Wiley.
Yahoo! Finance. (2016). KO Key Statistics. Retrieved from http://finance.yahoo.com/q/ks?s=KO
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