PepsiCo: A Great Play for Dividend Income Investors

In this article, let's take a look at Pepsico, Inc. (PEP, Financial), a $140.93 billion market cap company, which does not require too much introduction.

Q1 Highlights

Quarter results showed that revenues declined by 3.22% to $12.22 billion, mainly hit by two factors: the dollar and some weakness in emerging markets.

We must highlight the gross profit margin of the firm, which is considered very high, at almost 60% which has increased from the same quarter the previous year. Other ratio which is pretty attractive is the return on equity, which stood at 41.06% for the first quarter and doubled the industry median.

Major Shareholders

Several investors reported long positions in the stock at the end of the first quarter of 2015, including Donald Yacktman (Trades, Portfolio)’s fund, which held 25.48 million shares of the company valued at $2.44 billion. The position represents 11.23% of the equity portfolio and decreased over the quarter by 5%. Also, Ken Fisher (Trades, Portfolio)’s Fisher Asset Management owned 5.12 million shares.

Dividend Hike

The firm has an attractive dividend policy showing its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis and so returning billions to its shareholders annually. Dividends have been paid since 1952.

The past Tuesday, it has announced a 7.3% increase in its quarterly dividend to $0.7025 from $0.655 per share, which will generate an annualized dividend of $2.90 per share. The dividend yield was 2.75%, and with a closing price of $95.42 it will offers an annualized dividend yield of 3.04%.

Valuation

In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends according to John Burr Williams.

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

This formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)

where:

V0 = fundamental value

D0 = last year dividends per share of Exxon's common stock

r = required rate of return on the common stock

g = dividend growth rate

Let´s estimate the inputs for modeling:

Required Rate of Return (r)

The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%. This is a very low rate because of today´s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.

Beta: β =0.6

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rPEP = RF + βPEP [GGM ERP]

= 4.9% + 0.60 [11.43%]

= 11.76%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE=(Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Let´s collect the information we need to get the dividend growth rate:

Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. A smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= ($95.42 × 11.76% – $2.90) ÷ ($95.42 + $2.90) = 8.46%.

The growth rates are:

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

Final Comment

The price is below the intrinsic value, so we can say that the stock is undervalued, and so, in my opinion subject to a potential buy. When considering a margin of safety, usually in the order of 20%, we can conclude that the stock is fairly valued. But our buy recommendation is based on the upward trend the stock has shown. It was up by 1% in a year-to-date basis and we expect a continuation of that trend in 2015.

We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

Disclosure: Omar Venerio holds no position in any stocks mentioned.

[1] This values where obtained from Blommberg´s CRP function.