Coca Cola (NYSE:KO) has been approaching its 2013 high as bulls pile into the world’s largest beverage company. Analysts tend to be bullish on the stock giving shares an “overweight” rating on average and a $45/share price target giving the stock 5 percent upside. As you wait for that upside you can enjoy a 2.9 percent dividend, which is more than 1 percent higher than the dividend yield on the S&P 500; it is also higher than the ten-year yield.
So why not step in and join Warren Buffett in this cash-flow machine? There are three reasons not to.
The first is a technical reason. The stock is approaching a major resistance level of roughly $43.60/share. This was the weekly closing high for the stock way back in 1998. The stock hasn’t traded above that level since then. Now granted the stock hit that level when the American stock market was in the biggest bubble in its history. Still, when stocks reach technically significant resistance levels, they tend to pull back. Given that this is a particularly long-standing resistance level the pullback could be severe despite the fact that Coca Cola is considered to be a low-volatility safety stock.
The second reason is the valuation. The company trades at over 22 times earnings. While this is in line with the broader stock market, I still believe it is overvalued. Now 22 times earnings isn’t necessarily a high price to pay for a stock if it has sufficient growth. But Coca Cola has had no growth as of late. The company just seems to be generating consistent cash-flow and meanwhile the stock is drifting higher as investors look for safety and yield. At some point investors will realize that even safety stocks can be overvalued and they will start to sell their positions, and this could send the stock lower unless the company begins to grow its earnings in a meaningful and sustainable manner.
Third, the company has been buying back its shares at this elevated level when it could have put that money to use in better ways. Now it would have been difficult for the company to substantially increase its dividend in lieu of a buyback because it wants to maintain a slow, steady dividend increase rate. But it could have easily made more accretive acquisitions. Or it could have simply accumulated some cash that it could use should the opportunity arise.
Instead the company, like many, was operating on the theory that it makes sense to borrow money in order to buy back stock because the earnings yield on the stock (the inverse of the price to earnings multiple) is higher than the company’s borrowing rate. But what happens when interest rates rise and the company can no longer afford to do this? It will have to pay back its debt leaving it less capital for dividends and acquisitions. This short term thinking could prove to be devastating for what is, again, a “safe” company.
Ultimately Coca Cola is riskier than it appears to be. Investors can’s see how this is the case because they are only looking at the company as a strong, consistent cash-flow generator. This is certainly one ingredient for a successful investment but there are several others such as valuation and financial conservatism.
With these points in mind, I think that the risk is to the downside in this investor favorite. It is certainly a stock to keep on your radar, but it isn’t worth owning at the current price.
Disclosure: Ben Kramer-Miller has no position in Coca Cola.