Huong.dang@canterbury.ac.

nz

FINC311/ FINC614 Investments

Equity Valuation Case:
Coca Cola
Lucy Nguyen just joined Terra Nova Investments Ltd. in May 2011 as a graduate analyst. Her first
assignment is to value Coca-Cola, a company that has bought back stock between 2006 and 2010. In
2010 the company reported earnings per share (EPS) of $3.56 and paid out $1.88 per share in dividend.
Lucy conjectured that during the next 5 years the firm would be able to generate 25% as a return on
equity (ROE) on future investments, lower than its current ROE but close to its marginal return on
equity over the last few years.
Lucy gathers the following data about the total cash returned to stockholders each year from 2006 to
2010 and contrast the augmented payout ratio with the conventional payout ratio.
2006 2007 2008 2009 2010 Aggregate
Net income ($) $5,080 $5,981 $5,807 $6,824 $11,809 $35,501
Dividends ($) 2911 3149 3521 3800 4068 17449
Stock buybacks ($) 2268 219 493 856 1295 5131
Dividends + buybacks ($) 5179 3368 4014 4656 5363 22580
Dividend payout ratio 57.30% 52.65% 60.63% 55.69% 34.45% 49.15%
Augmented dividend payout ratio 101.95% 56.31% 69.12% 68.23% 45.41% 63.60%
The augmented dividend payout ratio is calculated as follows:
Augmented dividend payout ratio = (Dividend + Stock buybacks – Long term debt issues)/ Net
income.
The augmented dividend payout is higher than the dividend payout in each year, but stock buybacks are
volatile. Thus, Lucy decided to look at the augmented dividend payout ratio in the aggregate over the
entire period 2006-2010. Lucy was not sure whether she should use the augmented dividend payout
ratio (in the aggregate) or the conventional payout ratio (in the aggregate). She discussed with her
manager, Robert Kelly, CFA.
Robert emphasised that “Using the higher augmented payout ratio will result in higher cash flows to
stockholders in the high growth phase, which should increase value. This effect, however, will be partly
or even fully offset by a lower fundamental growth rate.”
Lucy conjectured that during the next 5 years of high growth period, the firm would reinvest about 36.4
of its earnings, which is consistent with the retention ratio that she derived using the augmented
dividends in the aggregate (see the Table above). Lucy also estimated that during the high growth
period, Coca-Cola’s beta is 0.9 and the equity risk premium is 2% above the current risk free rate.
After year 5, Lucy allowed for a transition period of a few more years to stable growth starting from
year 10. Lucy combined the following estimates for the transition period starting from year 6. However,
she forgot to indicate the payout ratio and the cost of equity estimates for year 10.
Year 6 7 8 9 10
Expected growth rate 7.88% 6.66% 5.44% 4.22% 3%
Payout ratio 66.88% 70.16% 73.44% 76.72% ?
Cost of equity 8.56% 8.67% 8.78% 8.89% ?
During the transition and stable growth periods, Lucy revised the beta but kept the equity risk premium
and the risk free rate unchanged. The beta of the firm in the stable growth period will be equal to the
beta of the market portfolio.
In the stable growth period Lucy assumes the following changes:

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Huong.dang@canterbury.ac.nz

- A return on equity (ROE) of 15%; while this is lower than the current ROE, it is an impressive
return for a mature firm and reflects her belief that Coca Cola’s brand name will endure
- Expected growth rate of 3% forever, set just below the current risk free rate of 3.5%
Lucy then presented her valuation model to Terra Nova Investments Ltd.’s three managers including
Christina Amarilli, Happy Magnolia, and Robert Kelly, CFA.
Robert Kelly, CFA commented that “Using your valuation model, the present value of the cash flows
realised during the high growth period will account for around 17% of the fair value of Coca-Cola’s
share”
Christina Amarilli added that “Using your valuation model, the present value of the terminal value will
represent 60% of the intrinsic value of Coca-Cola’s share.”
Happy Magnolia concluded that “Coca-Cola is currently trading at $68.22. If we consider a security
trading within a band of ±2% of your estimate of intrinsic value to be within a fair value range, then
Coca-Cola is overvalued.”
They all agreed that Lucy needs to run sensitivity analysis and finalise her investment recommendation
shortly.
Happy Magnolia stated that “If you set Coca-Cola’s beta in the stable growth period 25% higher than
your current estimate and keep other parameters constant, the terminal value will reduce by around
18.5%.”
Christina Amarilli further added that “If you set Coca-Cola’s stable growth rate equal to the current risk
free rate and keep other parameters constant, the terminal value will increase by around 9.5%.”

a. Calculate the growth rate derived from the conventional payout ratio (in the aggregate) and
the growth rate derived from the augmented payout ratio (in the aggregate) for the high
growth period.
a. Based on your answer in Part (a), comment on Robert Kelly’s statement “Using the higher
augmented payout ratio will result in higher cash flows to stockholders in the high growth
phase, which should increase value. This effect, however, will be partly or even fully offset
by a lower fundamental growth rate.”
b. Comment on Robert Kelly’s statement “Using your valuation model, the present value of the
cash flows realised during the high growth period will account for around 17% of the fair
value of Coca-Cola’s stock.” Show your detailed calculations for full credit.
c. Comment on Christina Amarilli’s statement “Using your valuation model, the present value
of the terminal value will represent 60% of the intrinsic value of Coca-Cola’s share.” Show
your detailed calculations for full credit.
d. Comment on Happy Magnolia’s statement “Coca-Cola is currently trading at $68.22. If we
consider a security trading within a band of ±2% of your estimate of intrinsic value to be
within a fair value range, then Coca-Cola is overvalued.” Show your detailed calculations for
full credit.
e. Comment on Happy Magnolia’s statement “If you set Coca-Cola’s beta in the stable growth
period 25% higher than your current estimate and keep other parameters constant, the
terminal value will reduce by around 18.5%.” Show your detailed calculations for full credit.
f. Comment on Christina Amarilli’s statement “If you set Coca-Cola’s stable growth rate equal
to the current risk free rate and keep other parameters constant, the terminal value will
increase by around 9.5%.” Show your detailed calculations for full credit.
g. Lucy then ran a sensitivity analysis in which she changed the equity risk premium and kept
other parameters constant. In this scenario, the present value of the terminal value increased

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by $3.9386. What was Lucy’s implied equity risk premium? Show your detailed calculations
for full credit.