Estimating Valuation Multiple Changes
Coca-Cola currently trades for $45.63 per share. The company has $1.97 in adjusted earnings over the last 4 quarters for a price-to-earnings ratio of 23.2.
From 2006 through 2015 Coca-Cola had an average price-to-earnings ratio of 18.6. The company’s price-to-earnings multiple traded for an 8% premium to the S&P 500’s price-to-earnings multiple over this time period.
S&P 500 stocks very clearly overvalued from a historical perspective at current levels.
There are 2 questions surround Coca-Cola’s price-to-earnings ratio:
- Will it maintain its historical premium to the market in 5 years?
- Will the market still be overvalued in 5 years?
When one makes projections, one should always err on the side of conservatism .
Coca-Cola’s core soda business is experiencing headwinds in developed countries that are likely to persist indefinitely. On the other hand, the company is a market leader that still has growth potential internationally and with its still beverages. A price-to-earnings ratio in line with the S&P 500 is conservative, in my opinion, on balance.
The question of whether the market as a whole will be overvalued in 5 years is more difficult to answer. Low interest rates naturally lead to higher market values. Interest rates will very likely still be low 5 years from now.
Here are 3 different scenarios for the next 5 years:
- Market reverts to historical price-to-earnings ratio of 15.6
- Market maintains its current overvalued status at 25.0
- Market mediates to a price-to-earnings ratio of around 20
I believe that all 3 of these scenarios are about equally likely. The average of these scenarios is a price-to-earnings ratio of 20.2. We will use 20.2 as our expected price-to-earnings ratio for Coca-Cola 5 years in the future.
This is just guessing at the future however. Estimating a reliable price-to-earnings ratio into the future is very error-prone.
The image below shows the company’s change in expected price-to-earnings ratio over the next 5 years:
The above assumes a compound price-to-earnings multiple growth rate of -2.7% per year. We can expect that valuation multiple changes will be a drag on Coca-Cola’s performance.
The steps to calculate valuation multiple changes are below:
- Find current price-to-earnings ratio
- Estimate expected future price-to-earnings ratio
Calculate compound annual growth rate of price-to-earnings ratio