business & industry analysis - texas tech...

PEPSICO VALUATION 28 April 2005

EMON SILA [email protected]

MATT BALLARD [email protected]

TABLE OF CONTENTS

Executive Summary……………………………………………………… 2

Business & Industry Analysis……………………………………… 5

Five Forces Model....... ……………6 Competitive Strategy Analysis…..…9 Key Success Factor…....……….... 10

Accounting Analysis………………………………. 13 Key Accounting Policies…..…… 14 Screening Ratios ………..……... 21

Ratio Analysis & Forecast Financial……………… 25

Firm Analysis……………………. .26 Cross Sectional Analysis……...….. 30

Financial Statements Forecasting… 46

Valuation Analysis………………………………..…48

Method of Comparables……………48 Free Cash Flow……………………..51 Discounted Dividend……………….53 Discounted Residual Income……….54 Long Run Residual Income………...56 Abnormal Earning Growth…………57

Appendix……………………………………………60

1

Executive Summary

I Executive Summary

Investment Recommendation: Slightly Overvalued Sell

PEP – NYSE $53.63 52 week price range $47.37 - 55.71 Revenue (2004) 29,261 (mill) Market Capitalization 89.99B Shares Outstanding 1.68B Dividend Yield 1.72% 3-month Avg Daily Trading Volume 3,251,909 Percent Institutional Ownership 66.44% Book Value Per Share (mrq) 8.083 ROE 31.24% ROS 53.68% Cost of Capital Estimates Beta Ke Ke Estimated 5yr Beta .32 2.57% 3yr Beta .76 5.6% 2yr Beta .48 3.69% Published Beta .65 4.88% Kd 3.98% WACC 4.80%

Valuation Ratio Comparison PEP Ind Avg Trailing P/E 22.1 19.4 Forward P/E 20.69 19.18 Forward PEG 1.88 2.19 M/B 6.47 4.55 Valuation Estimates Actual Current Price (April 1, 2005) $52.76 Ratio Based Valuations P/E Trailing $49.47 P/E Forward $48.92 PEG Forward $50.80 Dividend Yield $39.72 M/B $37.07 Ford Epic Valuation $71.33 Intrinsic Valuations Discounted Div $43.18 Free Cash Flows $47.90 Residual Income $51.80 Abnormal Earnings Growth $54.13 Long-Run Residual Income Perp $56.20

2

Executive Summary

As we mention previously PepsiCo is a world leader in convenient food and

beverages, with revenues of about $29 billion in 2004. The company consists of the

snack business of Frito-Lay North America, PepsiCo Beverage Int’l, PepsiCo Beverages

North America and Quaker Foods North America. PepsiCo (PEP) shares are traded on

the NYSE in the United States. PepsiCo has implemented cash dividends since the

corporation was founded. Besides NYSE, this company is also listed on the Amsterdam,

Chicago, Swiss, and Tokyo stock exchange (www.pepsico.com). We have found that the

non-alcoholic beverage industry is dominated by three major players which are PepsiCo,

Coca-Cola and Cadbury Schweppes. There is tremendous competition within a relatively

slowing industry. This industry is known for the rivalry between Pepsi and Coke over the

years. PepsiCo currently controls nearly 21% of this industry. On the other hand Frito-

Lay controls 60% of the U.S snack-food market. Switching costs are virtually inexistent

in this industry. Within the industry there are large economies of scale and it is hard for

new entrants in this industry. PepsiCo has done a great job of building a great brand

name, rivaling that of Coca-Cola. In PepsiCo’s industry there is a considerable threat of

product substitution. PepsiCo has a low bargaining power of suppliers because like Coke

they own their bottling companies. PepsiCo’s competitive strategy is also based on

differentiation instead of cost leadership. This means that they have to highly invest in

new flavors, formulas, and packaging to compete with their competition. PepsiCo has a

flexible distribution network; products are brought to the market through vending

distribution networks, direct store delivery, and broker-warehouse.

After extensive review of PepsiCo’ accounting practices we feel highly

confident in their financial disclosures. We analyzed several aspects including: key

accounting policies, accounting flexibility, accounting strategy, quality of disclosures,

potential red flags, and screening ratios. While there were a few discrepancies, the

importance of the errors weighted very little on our analysis. By targeting these aspects

individually we were able to dissect and examine the underlying procedures of PepsiCo.

We determined that their key accounting policies and strategies are directly in line with

industry practices. Also, in dealing with account flexibility we determined that there was

some flexibility and changes in accounting procedures but these were in line with actions

3

http://www.pepsico.com/

Executive Summary

of regulation and industry standards. Quality of disclosures was adequate in regards to

voluntarily giving information to investors. After review we determined that there were

no main causes for alarm. While there were some activities that looked suspicious, after

further investigation we determined them to be of minor consequences. Finally,

screening ratios were used to determine if there were any potential manipulations.

Overall these ratios were fairly consistent over the years. Also, comparing PepsiCo to the

industry further supported our decisions, in that they were consistent with that of

competitor’s ratios.

We analyzed PepsiCo using the liquidity, profitability, and capital structure

categories of ratios. By doing this analysis we founded that PepsiCo is relatively liquid,

has a moderately favorable profitability and that capital structure has a moderately

positive analysis. PepsiCo financial statements are reasonably transparent. They are

reported on quarterly basis. These financial statements give their shareholders and

investors good and clear inside information about PepsiCo. The forecasting that we did

for PepsiCo financial statement showed a steady growth for the next 10 years. PepsiCo

has an excellent growth potential for the years to come because Frito-Lay, Pepsi-Cola,

Quaker Oats, Gatorade, and Tropicana brands all have strong market position in North

America. Our forecasted financial statements are free of errors and we don’t assume that

our forecast it is going to be accurate because as we know the longer the period of

forecast the less accurate the forecast will be.

We valued PepsiCo based on six valuation models. These models include the

following: Method of Comparables, Discounted Free Cash Flows, Discounted Dividends,

Discounted Residual Income, Abnormal Earning Growth and Long Run Average

Residual Income Perpetuity based on the P/B ratio. Valuation is the process of converting

the forecast that we did for the company into an estimate of the value of the firm. To use

this method we had to find the Kd, Ke and WACC of the company. We did this by

considering the risk of the company and by calculating how much of the firm is financed

with debt and equity. In all these models except the abnormal earning growth model, the

actual price exceeds our estimated price. These models show that PepsiCo as slightly

4

Business & Industry Analysis

overvalued by an average of $3.51 per share. In most of these models the change of the

growth rate was the most sensitive factor of change, besides the discounted residual

income where the cost of equity was the sensitive factor of change. Even though there

may be some errors in the models, we feel that PepsiCo stock price is slightly overvalued

and we recommend investors to sell this stock.

II Business & Industry Analysis

PepsiCo was founded in 1919 in Delaware and was reincorporated in North

Carolina in 1986. Now this company is one of the world leaders in snacks, foods and

beverages. (www.pepsico.com). PepsiCo produces and market different kind of salty,

convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages.

PepsiCo had revenue of about $29 billion in 2004, 27 billion in 2003 and over 200,000

employees. The company is organized in four divisions which consist of the Frito-Lay

North America, PepsiCo Beverage North America (Pepsi-Cola America and

Gatorade/Tropicana North America), PepsiCo International, and Quaker Foods North

America. The international division operates in around 200 countries. The largest of

operations are held in United Kingdom and Mexico (www.pepsico.com). PepsiCo has

emerged as a vast and diverse company, involved in beverages as well as snack foods.

PepsiCo’s division Frito-Lay holds a significant leadership in the snack industry even

though is faced with different competition everyday. The company produces eight of the

ten best selling snacks in the nation. Frito-Lay controls 60% of the U.S. salty snack-food

market and has the number one position in corn chips, potato chips, tortilla chips and

pretzels (www.finance.yahoo.com). The beverage industry is dominated by three major

players which together control the global market. These players are Coca-Cola, PepsiCo,

and Cadbury Schweppes (Dr Pepper and Seven Up). For years this industry is known for

the war between Coke and Pepsi on the cola principals. Now this war has ended and the

industry’s giants have been focusing in on creating new product flavors to compete with

each other.

5



http://www.finance.yahoo.com/


Five Forces Model

Competitive Force 1: Rivalry Among Existing Firms

Due to the fact that this industry’s growth has had relevantly little growth over the

years, there is tremendous competition within the industry. This industry has low

concentration. Three major firms account for 80% of the global market. These firms

include PepsiCo, Coca-Cola, and Cadbury Schweppes. Coca-Cola has achieved 50% in

global market share, while PepsiCo controls 21%, and Cadbury Schweppes maintains 7%

(www.finance.yahoo.com). Competition amongst these firms is not mainly based on

price competition but rather product differentiation. Many firms rely on new flavors and

have also branched into non-carbonated beverages and snack foods to give there firm a

competitive advantage over others. PepsiCo has also been exceeding in this by acquiring

Quaker Oats which owns Gatorade. PepsiCo has also added Tropicana, Aquafina, and

Lipton into its product line making PepsiCo number one in the non-carbonated beverage

industry. Coca-Cola has also entered into this arena by emerging with Nestea, Powerade,

and Minute Maid brands to compete in this movement. PepsiCo has also branched into

the breakfast and snack food industry with Quaker Oats and Frito-Lay. While PepsiCo

has remained at number two in soft drinks, this diversification has helped make up the

difference in competition. Switching costs are virtually inexistent in this industry as there

are no costs for consumers to switch products. The only costs to switching would be a

different taste, appearance, and appeal. This is mainly due to the fact that firms have

cooperated to maintain the same price for there products. Consumers are faced with a

decision of choosing a product not based on price but rather on style, taste, and other

contributing factors. Under these circumstances, companies have spent considerable

energy to market there products to achieve brand awareness. There is also a tremendous

learning curve for these companies, resulting in extreme barriers to entrance of other

emerging companies. Most companies have developed extensive distribution systems

and have created relationships with suppliers and buyers. Also there are extensive

economies of scale resulting in companies with massive size. This has been created by

obtaining extreme amounts of capital and diversifying the company into other markets.

6



In this type of industry there are relatively few exiting barriers which have left only a few

companies to compete in.

Competitive Force 2: Threat of New Entrants

Within this industry there are large economies of scale. This results in an extreme

amount of capital to propel the company. Using capital for manufacturing isn’t much of

a concern as there are generic brands which cost less. Much capital is used to market and

advertise there products to achieve brand awareness and differentiate there products from

others. PepsiCo has done a tremendous job by creating a household name rivaling that of

Coca-Cola’s. Such common household names are Pepsi, Mountain Dew, Gatorade,

Tropicana, Lipton, and Quaker and Frito-Lay products. New companies trying to emerge

into the industry have a distinct disadvantage due to the fact that the top companies have

already developed such traits. This has caused new companies to not be able to compete

head on with rivals. Also companies within the industry have developed extensive

arrangements and relationships with manufactures and distributors. PepsiCo for example

has Pepsi Bottling Group. This independent entity makes, sells, and distributes Pepsi

brands around the world.

Competitive Force 3: Threat of Substitute Products

In PepsiCo’s industry there is a considerable threat of product substitution.

Products offering the same qualities and features at a lower price can initiate customers to

substitute. In this day of age of health consciousness, new products have been developed

to meet this trend. To meet this concern many of the companies offer healthier

alternatives that ultimately cut into their other brands profits. Brands such as Pepsi One,

Diet Pepsi, and Coca-Cola’s C2, and Diet Coke have been developed to meet this concern

head on. Another concern is that of generic brands such as grocery store brands. The

relative concern is based on price. For example most grocery stores have their own

brands of soda, juices, breakfast, and snack items. While the top companies have there

7


own distinct image, these generic brands offer a similar taste but at a much lower price.

This industry’s main concern is if customers become price conscious and stray away

from popular brands such as PepsiCo products. As long as consumers place value on

these companies products there shouldn’t be that much of a concern.

Competitive Force 4: Bargaining Power of Buyers

PepsiCo is more sensitive to price due to the fact that there are low switching

costs involved in producing their products. Because the total cost of manufacturing their

product comes from packaging, PepsiCo is more apt to search for the lowest price of their

raw materials being that are readily available and are a common material (i.e. plastics and

aluminum). Being that PepsiCo is such a large producer enables them to hold a strong

bargaining position. Since they buy so many raw materials they are able to get lower

prices for them buying in such bulk. Also the number of readily available materials to

PepsiCo increases their bargaining power due to the fact if a specific supplier can not

match a price or does not have the material available; it is not difficult to find it quickly

and inexpensively. However these packaging and distribution expenses are taken by

Pepsi Bottling Group which is a separate entity of PepsiCo and became publicly traded in

early 1999. Even though PBG is a separate company; PepsiCo owns 40% of PBG’s

equity interest. (www.msn.com)

Competitive Force 5: Bargaining Power of Suppliers

There are many different suppliers in PepsiCo’s industry. These suppliers are

the bottlers and metal can suppliers. PepsiCo is in a unique position in which it used to

own Pepsi Bottling Group. In 1999, Pepsi Bottling Group became independent and in

which PepsiCo retains 40% of its shares. Because of this suppliers of bottlers have a

relatively low bargaining power relative to PepsiCo because they are a continued vested

interest of PepsiCo. This makes PepsiCo able to have a distinct advantage over other

competitors in production and distribution. Pepsi Bottling Group also provides other

8

http://www.msn.com/


ingredients that are used in the food and beverage businesses, these include: almonds,

cocoa, corn, flavorings, flour, juice, oranges, potatoes, and different kind of

fruits.(www.pepsico.com) This gives PepsiCo the chance to produce low cost products

over competitors. PepsiCo also employs specialists to secure the best suppliers that are in

the market for many of these items in order to produce quality products too.

Competitive Strategy Analysis

The beverage and snack industry is very competitive. Their competitive strategy

is based on differentiation instead of cost leadership. This means that the giants of the

business like PepsiCo should explore new formulas, flavors and appearances to compete

with each other. This is what PepsiCo is already doing by introducing two different lime

flavor drinks by the end of this month. PepsiCo is known for producing a variety of

salty, sweet and grain-based snacks, carbonated and non-carbonated beverages and

foods. They invest many resources to produce superior products and in marketing for

brand awareness. This is one of the reasons that PepsiCo has been one of the leaders in

the beverage and snack industry.

Another competitive advantage that PepsiCo has is its non-carbonated beverage.

PepsiCo has lost the war against Coke for the carbonated beverages, but they are the

leader in the non-carbonated beverages category. They have done this by adding

Gatorade’s 73% share of the sports drink market to its Tropicana and Lipton tea holdings.

(www.finance.yahoo.com) This means that PepsiCo is not only focusing on competing

with Coke on the carbonated beverages but they are looking to win battles in other

competitive areas. This is going to make PepsiCo maintain a competitive advantage over

a wider array of its competitors.

Another competitive advantage of PepsiCo is their flexibility of their distribution

network. PepsiCo products are brought to the market through direct-store delivery,

vending distribution networks and broker-warehouse. This distribution system is

9




developed in a way to satisfy customer needs and to show product characteristic. By

having a flexible distribution network PepsiCo is going to maintain their great reputation

and their product are going to satisfy their customers. The last competitive advantage that PepsiCo has is its capital. PepsiCo is number

one in the snack industry, number two in the non-alcoholic industry and they have

revenue of about $29 billion. This means that they have excess money to spend on

advertising, quality of products and differentiation. PepsiCo by having such great capital

provides advertising, sales and promotional support to their beverage and food

customers. That’s why PepsiCo has some of the most-recognized advertising in the

world. By having such extensive capital PepsiCo is making some research and

development to find new flavors and to produce an even higher quality product. In

conclusion PepsiCo believes that their capital, differentiation, flexibility of their

distribution network and their non-carbonated beverage is going to allow them to

compete efficiently.

Key Success Factor

Strengths:

One of the biggest strengths of PepsiCo is its Officers and Directors. They are a

master of being honest, having analytical assessment and they have no shyness in terms

doing what needs to be done. Minority Business News names PepsiCo Chairman and

CEO Steve Reinemund “Executive of the Year.” (www.Forbes.com). It is because of

them that the PepsiCo is one of the best companies in the beverage and food industry.

Another strength of this company is their division Frito-Lay which has surpassed

companies of all sizes through a combination of restructuring, new products, and lower

prices. While Coke is synonymous with soda, so are Frito-Lay’s Fritos is with corn chips

demonstrating its product-name association. Like James Stack an editor of InvesTech

Research says, “While the company trails Coca Cola on the soft-drink industry, in the

snack foods, Frito-Lay which controls 60% of the U.S. salty snack-food market, has the

number one position in corn chips, potato chips, tortilla chips and pretzels.” They are the

10

http://www.forbes.com/


best-run company in the food business. For the twelve months ended Sept, 4, 2004

PepsiCo earned $3.93 billion on sales of $16.49 billion. This shows that company is very

profitable, has a good financial footing, and is continuing to grow.

While the soft drink segment is, as ever, PepsiCo is number 2, but is an

extremely strong number 2. They control 21% of the soft-drink market. It is going to be

hard to compete with Coke in the soft drink industry but PepsiCo is not just staying and

accepting defeat. The company’s purchase of The Quaker Oats Company and its

Gatorade brand show that they are still highly competitive.

Weaknesses:

Pepsi maybe is one of the weaknesses of PepsiCo due that is really far from the

leader Coca-Cola in the international market. Coke is three times Pepsi's size in fountain

sales and has more than ten times as many salespeople as Pepsi. In the U.S., Pepsi's

market share lags behind Coke's by the widest margin in over two decades. The net sales

of PepsiCo had increase in the past years but it is important to notice that this increase is

only because of sales in USA. Internationally, Pepsi's drink business was a mess. They

still haven’t figured out a way to increase their sales in the international market. But

lately they have improved internationally and especially after Coke have lost a lot of sales

in Europe. But PepsiCo has showed difficulties in the past in the international market and

they are trying very hard to improve these weaknesses. Another weakness is their

historically late entrance into carbonated beverage industry. Coca-Cola entered the

market in 1886 while Pepsi emerged in 1919 giving Coca-Cola a three decade head

start.(www.pepsico.com) Regardless of PepsiCo’s size, diversification, business acumen

or bottom line, consumers still see the company as only Pepsi, a product. While Coke has

fans (collector’s clubs, items, Christmas tree ornaments, etc.), Pepsi has purchasers.

Opportunities:

11



There are still some undeveloped markets in the world that PepsiCo should try

to penetrate. They need to look for these markets and get established there before their

competitors. PepsiCo traditional carbonated soft drinks and salty snacks continue to

symbolize the company and it is going to do so for a long time. But you have to be risky

to succeed in business and to beat your competition. PepsiCo is thinking about taking a

risky strategy to make at least half of its new-product offering “nutritious” (www.new-

nutrition.com). We know that we live in a society where many people are worried

about their nutrition. We hear about this topic through the media and we read it in

magazines all the time. New good-for-you products from PepsiCo are going to include

soon dairy products, more whole-grain items in its Frito-Lay line of salty snacks,

products based on olive oil and a soy-enhanced Tropicana orange juice. This is going to

be a great opportunity for PepsiCo to make healthier product and to expand its market.

The key for the beverage companies is differentiation. The giants of the industry have

different formulas and appearances. PepsiCo for being one of these giants has the

opportunity to make better formulas and appearances for their customers so they can beat

their competition. PepsiCo is going to introduce a lime-flavored soda that is going to

compete with a similar offering of their rival Coca-Cola. By using a better formula and

appearance and a great advertising plan in these new drinks, they have the opportunity to

beat Coca-Cola.

Threats:

The prices of the items that PepsiCo purchase are subject of fluctuation. For

example the increase the prices of the raw materials or the fuel can cause an increase of

the costs of the production of their product, and in the business environment that PepsiCo

operates, it is not possible to increase the product price because they are part in a very

competitive environment. In the marketing department the PepsiCo brand image is very

much linked to Pepsi image, which has label of second best brand. This can still give

them the label of ‘loser’, linking its image to the rest of firm’s company. This can give

them a bad brand image in their markets. They need to improve in their marketing

12

http://www.new-nutrition.com/


Accounting Analysis

department through advertising campaigns where they are appeared together with other

PepsiCo Brands.

Conclusion:

PepsiCo has established itself as a very stable and profitable company in North

America and all over the world. As we mentioned above they are number two in the non-

alcoholic beverage industry and number one in the snack industry by owning Frito-Lay.

PepsiCo, Inc operates four major businesses: Frito-Lay North America, 34% of the sales

and 41% of operating profit; PepsiCo Beverages 29% of sales and 30% of operating

profit; Quaker Food 5% of sales and 9% of operating profit; PepsiCo Int’l 32% of sales

and 20% of operating profit. (Value Line) All these brands have a strong market

position in North America and because of these PepsiCo has a growth potential for the

years to come.

III Accounting Analysis

The next process of analyzing PepsiCo was to look at their accounting

activities. The following sections contain both the qualitative and quantitative methods

to evaluate the credibility of PepsiCo financial statements. The qualitative method

consists of five steps: key accounting policies, potential accounting flexibility, strategy

analysis, quality of disclosures, and potential “red flags.” Based on our analysis we did

not undo any accounting distortions. After our evaluation of the financial statements and

footnotes, we feel confident that PepsiCo’s accounting practices are not misleading or

distorted. The quantitative method consists of evaluating ratios to see the reliability of

PepsiCo financial results.

13

Accounting Analysis

Key Accounting Policies

PepsiCo is a manufacturing company that must compete in research and

development, product defect after the sale and product quality and innovation. PepsiCo

key accounting policies are revenue recognition, brand and goodwill valuations, income

tax expense and accruals, stock compensation expense, and pension and retiree medical

plans. These policies require management to make difficult judgment about uncertainties

and these results may significantly impact their financial results. PepsiCo needs to focus

on these key accounting policies to maintain a competitive advantage over it competition.

One of the most important key accounting policy for PepsiCo is revenue

recognition. They recognize revenue upon delivery to their customers in accordance with

written sales agreements that do not allow for a right of return. PepsiCo wants to

maintain a high reputation for its superior products. This is achieved by implementing a

policy for direct-store delivery with chilled fresh products, to remove and replace

damaged and out-of-date products. This ensures that their customers receive the highest

of quality and freshness from their products.

Another key accounting policy for PepsiCo is brand and goodwill valuations.

Many of their brand names have been developed by PepsiCo management. They believe

that a brand has an indefinite life if it has significant market share in a stable economic

environment, and a strong revenue and cash flow performance. Brands that don’t meet

these criteria are amortized over their expected useful lives. PepsiCo purchases brands

and goodwill in acquisitions in which are not amortized. They are recorded annually to

ensure that estimated future cash flows continue to exceed their relative book value. As

of December 27, 2003 PepsiCo had $4.7 billion of perpetual brands and goodwill, of

which nearly 75% related to Tropicana and Walkers.

14

Accounting Analysis

Income Tax Expenses and Accruals is another key accounting policy for PepsiCo.

They determine their annual tax rate based on their income, tax planning opportunities,

statutory tax rates, and significant judgment. Their annual tax rate was 28.5% in 2003.

The annual tax rate reflected in PepsiCo financial statements is different from that

reported in their tax return. Also due to tax laws, timing differences that create deferred

tax assets and liabilities must be shown.

Stock Compensation Expense is another key success factor for PepsiCo. PepsiCo

believes that rewarding employees based on there performance will ensure a more

productive workforce. At the end of 2003, PepsiCo board put in effect a new

compensation program, which makes the link between pay and individual performance

stronger. They achieved this by varying the amount of long-term compensation for each

employee based on individual performance and responsibility. This new program

provided employees with the choice of being granted stock options or restricted stock

units (RSUs). This new program is expected to reduce the stock compensation expense

for 2004 from $407 million in 2003 to $360 million.

The last key accounting policy for PepsiCo is pension and retiree medical plan

expenses. Their pension plans cover employees in USA and certain international

employees. They measure their annual pension and retiree medical expense based on

many assumptions. These include: the interest rate used to determine the present value of

liabilities, the expected return on plan assets, the rate of salary increases of plans where

benefits are based on earnings. Also they use certain employee-related factors such as:

turnover, retirement age, mortality, retiree medical benefits, and health care cost trend

rate. In 2003 PepsiCo’s pension and retiree medical expense was $157 million and $116

million respectively. In 2004 they are estimated to be $245 million and $120 million.

15

Accounting Analysis

Accounting Flexibility:

For PepsiCo there are a few recently adopted new accounting standards, but are

not expected to have a material impact on the bottom line of the consolidated financial

statements. This company has historically implemented accounting methods that make

their financial statements to reflect the truest economic reality possible.

PepsiCo products are sold for cash or on credit terms. The credit terms require

that the payments arrive within 30 days of delivery and awards discounts to customers for

early payments. Revenue is recorded at the time of delivery to customers. PepsiCo

management develops their own brand name and they also purchase brands through

acquisitions. The brands developed costs are expensed as incurred, and the purchase

price of brands is allocated under identifiable assets and liabilities based on estimated fair

value. Any remaining purchase price is recorded as goodwill. If brands meet the

criteria, they have an indefinite life. If a brand cannot live up to the set of standards, it is

amortized over its expected useful life. Goodwill and perpetual brands are not amortized;

they are assessed for impairment. A perpetual brand is impaired if its book value exceeds

its fair value. On the other hand, goodwill is impaired if the book value of its reporting

unit exceeds its fair value. If the fair value of an evaluated asset is less than its book

value, the asset is written down to fair value based on its discounted future cash flow.

PepsiCo recently changed methods to account for employee stock options. Under

the intrinsic value method, they did not recognize any stock compensation expense

because they grant their stock options at the current stock price. So at the end of 2003,

PepsiCo changed their way of measuring employee stock options. They adopted the fair

value method for accounting for stock options as described in SFAS 148, Accounting for

Stock-Based Compensation- Transition and Disclosure. Now the accounting procedure

recognizes stock compensation expenses from the date of grant to the vesting date.

Under this method, the expected value that employees will receive from the options is

16

Accounting Analysis

going to be based on a number of assumptions like interest rate, employee exercises,

PepsiCo stock price, and dividend yield.

Pension and retiree medical plans are other areas that show flexibility. These

plans are recorded as long-term liabilities for PepsiCo. The pension or retiree medical

benefits that are expected to be paid are expenses that are based on estimates. These

estimates include: factors such as the expected return on assets in their funded plans, the

rate of salary increase for plans where benefits are based on earnings, how long a person

will live after they retire, and on the interest rate used to determine the present value of

liabilities. If these estimates are not done accurately, the company will have an

overstated or understated net income.

Evaluating Accounting Strategy:

In order to assess if PepsiCo’s accounting strategies reflect true economic reality,

we had to evaluate the accuracy of their accounting policies. By comparing PepsiCo’s

policies with that of other firms in the industry, we were able to determine the differences

in strategies that could mean potential distortions. After careful review we determined

that PepsiCo’s implemented accounting policies are within the standards of the current

industry.

PepsiCo’s accounting policies are very similar in many aspects to other industry

competitors such as Coca-Cola and Cadbury Schweppes. One policy similarity is

revenue recognition, in which all companies recognize revenue when product titles are

transferred upon delivery. Also, the credit terms which require payment within 30 days

of delivery, are created in accordance with industry practices. This credit term policy is a

good business transaction that PepsiCo uses to collect money from their customers in a

short period of time. Another important similarity is brand and goodwill valuations.

Interestingly, PepsiCo and Coca-Cola use the same three criteria for evaluating goodwill

and other intangible assets. These include that assets with indefinite lives not be

17

Accounting Analysis

amortized, and that definite intangible assets are subject to amortization. They also

implement the same procedures to test for impairments that may result from a change in

future operations, economic downturns, or conditions present to indicate that carrying

value may not be recoverable.

Pension and retiree medical plans are very similar to the industry as well. They

each use estimations of the plan’s expected returns and risk characteristics. They adjust

these estimations based on the interest rate used to calculate the present values of the plan

liabilities, estimations of the maturity of the benefits, and increases in salary. Also,

advertising, marketing, and research and development are crucial to this industry. Even

though future value is created in these expenditures, all costs associated with these

ventures are expensed appropriately. Finally, the last policy reflects the treatment for

stock option via the fair value method. Coca-Cola, Cadbury Schweppes, and PepsiCo Inc

all have established the fair value method to account for employee stock options.

PepsiCo policies and estimates have been mostly realistic, but the company did

have a mistake in the earning release for the fourth quarter in 2003. They revised the

2002 and 2003 earning per share because of overstatements for stock option expenses.

This was something that does not normally occur in this company, but they explained that

is was a computational error. The revision increased the previously reported earnings per

share for 2003 by $0.04 to $2.05 and for 2002 by $0.02 to $1.68. This revision did not

have any impact on the company’s previously reported cash flow or division operating

profit because stock option expense is a non-cash charge. Even though such mistakes can

easily happen, erroneous financial reporting can overstate or understate earnings.

The firm made some changes in it accounting policies during 2003. One of these

changes was measuring employee stock options. Until 2003, they were using the

intrinsic value to measure this expense. The method that they were using measured the

stock compensation expense as the amount by which the market price of the stock on the

date of grant exceeds the exercise price. By using this method, they were not recognizing

any stock compensation expense because they granted their stock option at the current

18

Accounting Analysis

stock price. So by the end of 2003, they changed their method from intrinsic value to fair

value method of accounting for stock options. Under this method, they measure the stock

option expense at the date of the grant using the Black-Scholes valuation model. This

model estimates the expected value that the employees will receive based on different

assumptions such as interest rate, employee exercises, stock price and dividend yield.

The firm also restated their results using the fair value method. The impact of this

change is going to be recorded as unallocated expenses in each of the years presented.

Refer to Table 1 to see how the restatements affected the firm.

Table 1

2003 2002 2001

Operating Profit 407 435 385

Net Income 293 313 262

Net Income per common share $0.16 $0.17 $0.14

Quality of Disclosure:

PepsiCo provides to its investors and analysts adequate disclosures to assess the

firm’s business strategy. The quality of financial statements, accounting methods, and

information disclosed provided by the firm gives a true picture about their business.

Reports have shown that carbonated soft drink growth has been slowing overall

and that the brand name “PepsiCo” was declining during 2003. PepsiCo did not show

adequate information to its investors to explain these declines. They wrote a brief

paragraph in the Letter to the Shareholders to inform analysts and investors about this

current information. The paragraph though did not give any explanation or any remedies

19

Accounting Analysis

for this discouraging information. Instead, they disclosed information regarding the fact

that the firm has been growing in the past and is expected to grow in the future. The

letter talks about commitments to growth and in what sectors PepsiCo has achieved

growth. They also give a good description of the firm’s industry condition, environment,

and competitive positioning, but they did not disclose relevant information to their

investors about “bad news.”

PepsiCo discloses economic factors that affect the company. For example, some

of these factors include the exchange rate and political conflict. PepsiCo’s operations

outside of the United States generated approximately 35% of their net revenue of which

almost 20% comes from Mexico, United Kingdom, and Canada. The other 15% comes

from the rest of the world. By operating worldwide, the company is exposed to foreign

currency risks and political unrest. To prevent any losses and reduce the effect of the

foreign exchange rate, PepsiCo enters into primarily forward contracts with terms of no

more than two years. In 2002, PepsiCo hedged $2.1 billion Mexican pesos related to

their net investment in Pepsi-Gemex which resulted in a $5 million gain upon the

disposal of this investment.

PepsiCo does a job showing disaggregated performance information based on

their business segments. In there footnotes they present each segments accounting

information and address their strengths and weaknesses. Also, PepsiCo thoroughly

explains the reason why performances in certain segments have increased or declined.

For example, in the Frito-Lay division managers give relative information regarding what

products have performed good/bad and give adequate reasoning for both. In the

footnotes, managers also adequately explain the key accounting policies and assumptions

logically. For example when there are some significant changes in the firm’s policies the

footnotes give a good explanation for the reason of these changes.

Potential Red Flags:

20

Accounting Analysis

Based on our accounting analysis that we performed, we did not find anything

alarming for potential severe distortions in their accounting policies. We also felt very

confident in their reported numbers. We looked into the firm’s financial statements to

assess any unexplained changes in accounting policies. There has been a steady increase

in accounts receivable and accounts payable that most likely has been caused by the

steady increases in sales. There was also a large decrease in cash and cash equivalents,

but this could have resulted from the increase in short-term investments. Also, they have

been very consistent with valuing the amortization of there intangible assets. Although,

there was one fourth-quarter adjustment during 2003, this was due to a computational

error and was corrected immediately. There isn’t much cause of alarm since there hasn’t

been a history of errors in the past five years for this company. Another item that might

be concerning is the fact that PepsiCo has certain accounts on their financial statements

missing. This hindered us from calculating certain screening ratios in the following

section. Although this may be alarming, we still feel comfortable in PepsiCo’s

accounting methods. After careful review, we also believe that these numbers are

accurate and reflect the truest economic value possible. Screening Ratios

Sales Manipulation 2004 2003 2002 2001 2000Net Sales/Cash from Sales 1.12 1.11 1.1 1.11 1.07 Net Sales/Net Account Receivables 9.53 9.92 11 10.5 14.7 Net Sales/Inventory 19.1 18.7 18 18.7 27.9 Net Sales/Unearned Revenue NA NA NA NA NA Net Sales/ Warranty Liabilities NA NA NA NA NA Core Expense Manipulation Declining Asset Turnover 1.06 1.07 1.08 1.08 1.43 CFFO/Operating Income 0.91 1.08 1.05 1.09 1.04 Pension Expense/SGA Expense 0.06 0.09 0.05 0.01 NA CFFO/Net Operating Assets NA NA NA NA NA Total Accruals/Change in Sales NA NA NA NA NA Other Employment Exp/ SG&A NA NA NA NA NA

21

Accounting Analysis

In order to account for any possible manipulations of PepsiCo’s information we

calculated several screening ratios. The first three ratios test for sales manipulation with

in their accounting practices. The first ratio, net sales/cash from sales, indicates a slight

rise over the five-year period inferring that PepsiCo must be collecting less cash or is

increasing its account receivable form sales. The second ratio, net sales/net accounts

receivable, indicates a drastic drop in 2000 due to the fact that PepsiCo abandoned its

bottling operations when Pepsi Bottling Group was formed. Since 2000, accounts

receivable ratio has steadily decreased. This means accounts receivable has actually

increased in size, corresponding to the first ratio (net sales/cash from sales). The last

ratio, net sales/inventory, shows a slight decrease since 2000, which correlates with the

formation of the Pepsi Bottling Group in 2000. Other ratios were also selected to

evaluate PepsiCo’s accounting practices. These included net sales/ unearned revenues

and net sales/ warranty liabilities. Though, due to lack of information in the financial

statements these ratios could not be calculated. This may mean for a cause of alarm due

to the fact that PepsiCo could have purposely done this. One thing though that elevates

this concern is the fact that in PepsiCo’s sales agreements they do not allow for return

which would negate the net sales/ warranty liabilities.

Another set of ratios were analyzed to assess core expense manipulations. The

three ratios include: declining asset turnover, changes in cash flow from operations

divided by operating income, and pension expense in relation to selling and general

administration expenses. The declining asset turnover indicates a general level trend

since the formation of Pepsi Bottling Group that explains that assets are being used the

same relative to the sales generated. The next ratio is the change in cash flow from

operations divided by operating income. Pass levels were above one but in 2004 it fell

below; this indicates that PepsiCo’s accounts receivables are not being collected as

22

Accounting Analysis

quickly as they have previously been. This correlates with the sales screening ratios as

previously discussed. The last ratio is the pension expense in relation to the selling and

general administration expenses. On average since 2001, this has been on an upward

trend, although 2004 forecast are expected to decrease significantly. This is due to the

Medicare Prescription Drug Improvement and Modernization Act of 2003 (late

December 2003), which is forecasted to reduce pension liability by nearly $50 million.

As in the case of sales manipulation screening ratios, there were some ratios that could

not be calculated do to lack of information in the financial statements. This could also

mean a cause for alarm as well. One thing though is that PepsiCo actually might not have

these kinds of expenses in their financial statements.

By also looking at these key screening ratios compared to other competitors gave

a good description and benchmark of their accounting policies. By comparison of the

same ratios listed above to Coca-Cola we found some consistency in the numbers. The

reason for viewing only Coca-Cola was due to the fact that they are more highly

correlated with PepsiCo. This could be in size, operations, sales, and other factors

associated with their company.

Coca-Cola Sales Manipulation 2004 2003 2002 2001 2000 Net Sales/Cash from Sales 3.85 3.85 4.13 4.89 5.7 Net Sales/Net Account Receivables 10.12 10.06 9.33 10.67 11.64 Net Sales/Inventory 15.47 16.81 15.12 19.04 19.19 Core Expense Manipulation Declining Asset Turnover 0.71 0.78 0.81 0.9 0.99 CFFO/Operating Income 0.97 0.98 0.78 0.91 1.13 Pension Expense/SGA Expense 0.015 0.01 0.007 0.0068 0.0069

23

Accounting Analysis

First looking at net sales/ cash from sales indicates that PepsiCo is receiving more

cash from their sales than Coca-Cola. Although these numbers are substantially different,

on trend they seem very stable in comparison. Also net sales / net accounts receivable

seems very consistent as well. The show that both companies have had tremendous

decreases in their ratio’s over time. Another fairly good comparison is CFFO/ Operating

Income. By comparison both companies have very consistent ratios with both gradually

decreasing over time. This indicates that operating income is beginning to increase

relative to the cash flow from operations. By looking at these ratios across the industry

both companies seem very consistent with their accounting numbers. This evidence

further supports our claim that PepsiCo’s accounting methods are consistent with

industry practices.

Conclusion and Discussion:

After extensive review of PepsiCo’ accounting practices we feel highly

confident in their financial disclosures. We analyzed several aspects including: key

accounting policies, accounting flexibility, accounting strategy, quality of disclosures,

potential red flags, and screening ratios. While there were a few discrepancies, they were

of minor concern. By targeting these aspects individually we were able to examine the

underlying procedures of PepsiCo. We determined that their key accounting policies and

strategies are directly in line with industry practices. Also, in dealing with account

flexibility we determined that there was some flexibility and changes in accounting

procedures but these were in line with actions of regulation and industry standards.

24

Financial Analysis & Forecast Financials

Quality of disclosures was adequate in regards to voluntarily giving and posting

information to investors. After review we determined that there were no main causes for

alarm. While there were some activities that looked suspicious, after further investigation

we determined them to be of minor consequences. Finally, screening ratios were used to

determine if there were any potential manipulations. Overall these ratios were fairly

consistent over the years. Also, comparing PepsiCo to the industry further supported our

decisions, in that they were consistent with that of competitor’s ratios.

III. Financial Analysis and Forecast Financials

In this next phase of evaluating PepsiCo, we have computed financial ratios to

assess the performance of the company. We are going to forecast the financial statement

of the company for the next 10 years. From the financial ratio analysis we are going to be

able to benchmark against our competition in the non-alcoholic beverage industry as well

as compute the industry average. This step is very crucial since it can be used to evaluate

the company on an individual basis, or compare it against competitors. Another

implication is that is can address the company’s performance compared to the industry as

a whole. By establishing financial ratios we are able to get a more in depth look into the

company’s profitability, liquidity, and capital structure. This type of analysis is very

important to investors and shareholders because it going to show them more in depth the

strengths and weaknesses of PepsiCo.

25


Firm Analysis

2004 2003 2002 2001 2000

Liquidity RatiosCurrent Ratio 1.28 1.08 1.06 1.17 1.17

Quick Asset Ratio 0.95 0.75 0.72 0.76 0.8

Inventory Turnover 9.76 8 7.84 7.51 7.87

Days Supply of Inventory 37.41 45.6 46.55 48.61 46.39

Receivables Turnover 7.97 9.53 9.92 12.57 11.36

Sales Outstanding 45.77 38.3 36.79 29.03 32.13

Working Capital Turnover 15.51 52.37 69.56 31.5 30.55

Profitability RatiosGross profit margin 53.68% 53.56% 53.67% 59.46% 60.46%

Operating Expense Ratio 35.20% 35.07% 33.94% 43.10% 44.68%

Net Profit Margin 14.40% 13.23% 13.19% 9.88% 10.68%

Asset Turnover 1.05 1.06 1.07 1.24 1.11

Return on Asset 15.05% 14.09% 14.11% 12.26% 11.90%

Return on Equity 31.24% 30.15% 35.81% 30.76% 30.11%

Capital Structure RatiosDebt to Equity Ratio 1.07 1.14 1.53 1.51 1.53

Times Interest Earned 31.56 28.93 26.33 18.41 14.48

Debt Service Margin 0.75 0.67 0.76 0.84 0.99

Liquidity:

In order to assess the liquidity of PepsiCo several ratios were determined and

examined. Also by looking at the current year and past years we were able to get a clear

26


picture of the changes PepsiCo has faced. After careful examination of these ratios we

determined that PepsiCo is relatively liquid. We first examined the Current Ratio.

Overall PepsiCo had a favorable current ratio. This is shown by an increase from 1.17 in

2000 to 1.28 in 2004. This implies that current assets have grown more in relation to its

current liabilities. Although this picture looks good overall, PepsiCo has hit some speed

bumps along the way. This is shown in the decrease from 1.17 in 2001 to 1.06 in 2002.

This was the result of an increase in current liabilities by 21.1% with a relative minor

increase in current assets of 9.6%. An alternative ratio that captures a firm’s liquidity is

the Quick Ratio. This ratio analyzes the company’s ability to meet current obligations

based on higher liquid assets. Overall, the quick ratio has improved over the past five

years from .80 in 2000 to .95 in 2004. This indicates a favorable trend in which PepsiCo

has utilized more liquid assets relative to current liabilities, indicating that they can now

meet upcoming obligations quicker than in previous years. One factor constraining

liquidity is the declining Receivable Turnover of the past five years. This number has

decreased from 11.36 in 2000 to 7.97 in 2004. The reason of dramatic increase in 2001

of 12.57 was the result of the enormous increase in sales relative to the increase in

accounts receivables. Looking forward from 2001 shows how the ratio has declined in

other years, indicating that PepsiCo is collecting far less cash on sales than in previous

years. As a result this also indicates that PepsiCo has had reduced capability of turnover

in sales of credit. Seemingly, we were able to determine the Days Supply of Receivable;

which measures the performance of collecting receivables. Comparing past and present

performance also entails discouraging news for PepsiCo since the number of days until

accounts receivable are collected has steadily increased from 32.13 in 2000 to 45.77 in

2004. This can indicate that PepsiCo has had problems in credit terms and collecting

cash from customers. Another ratio implemented was Inventory Turnover, which has

increased slightly over the years. This number increased from 7.87 in 2000 to 9.76 in

2004 indicating that PepsiCo is more productive in using inventory. The major reason

for the decrease in 2001 to 7.51 was attributable to the tremendous increase in inventory

which increased an astonishing 44.75% from the previous years. This might have

occurred because of a increase in the estimate of expected sales for 2001. Corresponding

to inventory turnover is Days Supply of Inventory. This number has decreased rather

27


steadily from 46.39 in 2000 to 37.41 in 2004, although there was an increase in 2001 of

48.61. This infers that PepsiCo has been able to manage inventories effectively and

turnout more inventory relative to previous years. This could also imply a decrease in

storage costs and an increase in production efficiency. The last ratio used was the

Working Capital Turnover. This number has nearly been very erratic over the years,

implying volatile differences in working capital values compared to sales. This ratio

determines how effectively working capital is being used in terms of the turnover it can

help to generate. Currently there has been a negative impact on liquidity indicated by the

decrease in values from 30.55 in 2000 to 15.51 in 2004. This significance can further be

seen by the decrease from 69.56 in 2002 to 2004. This could hinder PepsiCo’s ability to

meet upcoming obligations if further operating performance decreased other sources of

liquidity.

Profitability:

By further assessing other ratios we were able to determine the performance of

profitability for PepsiCo. After careful review, we concluded that PepsiCo also has a

moderately favorable profitability analysis. Gross Profit Margin has decreased relatively

over the years indicating that that cost of goods sold has increased over the years of

which accounted for 42% of sales in 2004. This has a negative impact on the company

since it costs more to produce their products given their output. One positive outcome is

that PepsiCo is recovering a little, since the ratio is up from 53.56% in 2003 to 53.68% in

2004. Another positive affect has been the decrease in Operating Expense Ratio. This

ratio has decreased form 44.68% in 2000 to 35.2% in 2004. While although operating

expenses has increased slightly from 2003, the increase in sales have mitigated this

negative affect on the company. The reason for the sharp decline in 2002 was due to the

fact that operating expenses decreased while sales continued to increase. Changes in Net

Profit Margin have also lead to a positive impact on the company as well. Net profit

margin has increased from 10.68% in 2000 to 14.4% in 2004, although there was a

substantial decrease in 2001 of 9.88%. One discouraging aspect has been the descending

trend of Asset Turnover, in which has decrease from 1.11 in 2000 to 1.05 in 2004. This

28


indicates that PepsiCo has had trouble in utilizing their assets to generate sales in recent

years. The reduction, maybe due to the fact in which PepsiCo has been investing in long-

term assets such as plant, property, and equipment which takes longer to implement. The

major increase in 2001 was the direct result of the large increase in sales relative to the

increase in total assets. PepsiCo has also had a favorable steady increase in Return on

Assets which increases profitability. This is mainly achieved by the increase in the net

profit margin relative to the decrease in asset turnover. Currently, return on assets has

increased by 26.5% since 2000. Return on Equity has also slightly increased from

30.11% to 31.24% over five years with a slight deviation in 2002 of 35.81%. Overall, it

seems that there has been a relatively slight improvement which increases the

profitability of owner’s interest in total assets.

Capital Structure:

After further ratio analysis we concluded that PepsiCo’s capital structure has a

moderately positive analysis. The change in Debt to Equity ratio has meant positive news

for PepsiCo. There has been a relatively steady decrease from 1.53 to 1.07 over the five

years, indicating that the company utilizes more equity financing compared to debt than

in 2000. This a positive affect since financing business activities with debt can be more

expensive and increase the liabilities of the firm. By implementing more equity, PepsiCo

can fund activities cheaper within the firm. Times Interest Earned has also had positive

growth. This is attributed to the substantial decrease in interest expense caused by the

decrease in debt used for financing. This ratio has increased from 14.48 in 2000 to 31.56

in 2004. This indicates that PepsiCo has the ability to pay for current interest payments

fairly easily. One negative aspect is that Debt Service Margin has decreased from .99 to

.75, representing an increase in payment of notes payable currently due compared to

operating cash flows. This is somewhat disturbing news since this may raise some

questions is whether PepsiCo can meet these obligations.

29


Cross Sectional Analysis Liquidity

Current Ratio:

PepsiCo

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 1.17 0.71 0.62 0.66

2001 1.17 0.85 0.78 0.81

2002 1.06 1.00 0.76 0.88

2003 1.08 1.06 0.75 0.91

2004 1.25 1.05 0.81 0.93

Current Ratio

0

0.2

0.4

0.6

0.8

1

1.2

1.4

2000 2001 2002 2003 2004

PepsiCo

Coca-Cola

CadburySchw eppes

Industry Avg

By comparing PepsiCo to the industry, viewers are able to see how this ratio

increases the value of PepsiCo’s liquidity. In each year, PepsiCo has had a higher current

ratio than any competitor in the industry, in which the values are dramatically higher than

the industry averages. This indicates that PepsiCo has effectively been able to meet

short-term obligations better than competitors.

30


Quick Asset Ratio:

PepsiCo

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 0.80 0.39 0.36 0.38

2001 0.76 0.45 0.43 0.44

2002 0.72 0.61 0.44 0.52

2003 0.75 0.71 0.41 0.56

2004 0.95 0.71 0.56 0.64

Quick Ratio

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

2000 2001 2002 2003 2004

PepsiCo

Coca-Cola

CadburySchw eppes

Industry Avg

By also comparing the efficiency of companies to utilize higher liquid assets to

meet current obligations helps asses PepsiCo’s liquidity. Throughout the entire five years

PepsiCo has had a quick ratio higher than competitors. It is easy to see that while these

values are below one, PepsiCo values are dramatically higher than competitors. These

values are also correspondingly higher than each year’s industry averages, in which case

concludes that PepsiCo has higher liquidity in that it effectively manages higher liquid

assets in order to meet current liabilities.

31


Accounts Receivable Turnover:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 11.36 11.64 6.11 8.87

2001 12.57 10.68 6.75 8.71

2002 9.92 9.33 6.26 7.80

2003 9.53 10.06 5.99 8.03

2004 9.76 10.64 5.92 8.28

Accounts Receivable Turnover

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

PepsiCo’s accounts receivable turnover has varied with some respect to the

industry. This value was dramatically higher in 2001 indicating that PepsiCo had

considerably less accounts receivables than competitors. This trend has changed in 2004,

in which case this ratio has fallen below Coca-Cola’s but still above Cadbury Schweppes.

This concludes that Coca-Cola is currently gaining more cash from sales and is more

effective in gaining cash customers faster. While PepsiCo has accounts receivable below

Coca-Cola, this number is still above the industry average. This comparison helps to

indicate that PepsiCo’s current position isn’t a sign of a sever constraint on liquidity.

Another view supporting this is that PepsiCo’s accounts receivable turnover seems to be

rebounding, as this ratio rose from 9.53 in 2003 to 9.76 in 2004.

32


Inventory Turnover:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 7.87 5.09 4.25 4.67

2001 7.51 4.97 4.91 4.94

2002 7.84 4.87 4.79 4.83

2003 8.00 5.56 4.42 4.99

2004 7.97 5.57 3.67 4.62

Inventory Turnover

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

PepsiCo has also been an industry leader in inventory turnover. For the past five

years, PepsiCo has had values greatly exceeding that of competitors. This indicates that

PepsiCo is efficiently capable of moving and controlling inventories better than

competitors. Due to this trait, this greatly increases PepsiCo’s position in liquidity

compared to the industry.

33


Working Capital Turnover:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 30.55 -7.57 -4.06 -5.82

2001 31.5 -15.97 -10.28 -13.13

2002 69.56 18.55 -8.61 -8.61

2003 52.37 41.26 -8.42 16.42

2004 15.51 -2.77 -12.83 -7.80

Working Capital Turnover

-30-20-10

01020304050607080

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

By comparing competitors within the industry enable viewers to see that the

values for PepsiCo given the five years have been relatively stable. On average, PepsiCo

has been relatively efficient in managing working capital compared to the industry. This

helps alleviate the concern for the decrease in liquidity regarding PepsiCo current values

since they are well above the competitors and industry average.

34


Profitability

Gross Profit Margin:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 60.46% 69.67% 53.86% 61.77%

2001 59.46% 69.92% 52.93% 61.43%

2002 53.67% 63.68% 47.89% 55.79%

2003 53.56% 62.87% 48.63% 55.75%

2004 53.68% 64.69% 49.27% 56.98%

Gross Profit Margin

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

Compared to the industry, PepsiCo has had relatively poor performance in

managing their gross profit margin. This implies some concern in the profitability of the

company since PepsiCo’s values have always been less than the industry average. Coca-

Cola clearly is able to gain more profit on sales relative to other competitors. This raises

some concerns to the extent of PepsiCo’s ability to manage the costs of production.

While PepsiCo’s numbers have increased in 2004, this is still currently less than the

industry average.

35


Operating Expense Ratio:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 44.68% 44.58% 36.89% 40.74%

2001 43.10% 42.85% 37.54% 40.20%

2002 33.94% 41.23% 30.21% 35.72%

2003 35.07% 35.64% 34.23% 34.94%

2004 35.20% 39.83% 37.18% 38.51%

Operating Expense Ratio

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

Alone, PepsiCo has had positive improvement in controlling operating expenses.

But by comparing these ratios with other competitor provides a different picture. By

looking at the whole industry PepsiCo dominates Coca-Cola and Cadbury Schweppes in

operating an efficiently run business. This evidence greatly increases PepsiCo’s

profitability compared to competitors of the industry.

36


Net Profit Margin:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 10.68% 10.64% 10.84% 10.74%

2001 9.88% 19.80% 9.82% 14.81%

2002 13.19% 17.47% 10.34% 13.91%

2003 13.23% 20.66% 5.68% 13.17%

2004 14.39% 20.88% 6.40% 13.64%

Net Profit Margin

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

2000 2001 2002 2003 2004

PepsiCoca-ColaCadbury SchweppesIndustry Avg

PepsiCo’s net profit margin has change a lot over the five years period, although

they have had some moderate improvement into 2004. This improvement enabled

PepsiCo to be above the industry average, indicating that they are able to retain a

moderate percentage of sales. Compared to the industry, PepsiCo is lagging behind

Coca-Cola by 6.5%. This indicates that Coca-Cola is far more profitable in the sense of

sales. Although of its current position, PepsiCo is in every sense profitable in the

industry.

37


Asset Turnover:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 1.11 0.99 0.71 0.85

2001 1.24 0.91 0.77 0.84

2002 1.07 0.81 0.69 0.75

2003 1.06 0.78 0.63 0.71

2004 1.05 0.76 0.68 0.72

Asset Turnover

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

By industry standards, PepsiCo is very effective in producing a high volume of

sales in relation to its size of assets. PepsiCo is the leading company in this respect,

provided that they have outperformed the industry every year. Although their current

number has declined, this information alleviates some of the concerns of their ability to

mange their assets.

38


Return on Assets:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 11.90% 10.58% 7.68% 9.13%

2001 12.26% 18.08% 7.54% 12.81%

2002 14.11% 14.15% 7.17% 10.66%

2003 14.09% 16.16% 3.59% 9.88%

2004 15.05% 15.82% 4.34% 10.08%

Return on Assets

0.00%2.00%

4.00%6.00%

8.00%10.00%

12.00%14.00%

16.00%18.00%

20.00%

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

By comparison, PepsiCo’s return on assets has increased steadily throughout the

five years. PepsiCo for the most part has exceeded the industry average and is currently

slightly below Coca-Cola. Cadbury Schweppes has dramatically lagged the industry in

respect to this ratio. This is a good indication that PepsiCo is highly profitable in regard

to the industry.

39


Return on Equity:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 30.11% 23.37% 17.87% 20.62%

2001 30.76% 35.01% 18.40% 26.71%

2002 35.81% 28.96% 17.90% 23.43%

2003 30.15% 30.85% 12.28% 21.57%

2004 31.24% 31.16% 15.43% 23.30%

Return on Equity

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

PepsiCo has had some deviations in their return on equity over the years, mainly

in 2002. This is quite normal considering the changes in values of other competitors.

PepsiCo currently has the same return as Coca-Cola indicating that these two firms are

very profitable in terms of owner’s interests in assets. This further provides evidence that

PepsiCo is highly profitable in the current industry.

40


Capital Structure

Debt to Equity Ratio:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 1.53 1.21 1.49 1.35

2001 1.51 0.94 1.61 1.28

2002 1.53 1.05 1.64 1.35

2003 1.14 0.91 2.64 1.78

2004 1.07 0.97 2.47 1.72

Debt to Equity Ratio

0.00

0.50

1.00

1.50

2.00

2.50

3.00

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

PepsiCo is currently slightly below Coca-Cola. Coca-Cola on average has had a

ratio less than the industry. This shows that PepsiCo has made substantial improvement

in reducing the amount of debt used to finance business activities. These improvements

seem to have a decreasing trend indicating further reduction may occur.

41


Times Interest Earned:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 14.14 11.49 5.67 8.58

2001 19.86 18.52 5.75 12.14

2002 27.37 27.43 6.78 17.11

2003 29.86 32.19 3.39 17.79

2004 31.56 32.85 4.10 18.48

Times Interest Earned

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

2000 2001 2002 2003 2004

Pepsi

Coca-Cola

CadburySchw eppes

Industry Avg

This trend indicates that PepsiCo and Coca-Cola can pay interest payments on

current and long-term liabilities rather easily. Cadbury Schweppes on the other hand

seems to struggle in meeting these current obligations. While Coca-Cola is in reality

better to meet these interest charges, PepsiCo still adequately provides income from

operations to cover these expenses. Given this environment there is a dramatic difference

between the top and low performing firms.

42


Debt Service Margin:

Pepsi

Coca-

Cola

Cadbury

Schweppes

Industry

Avg

2000 (0.99) (0.74) (0.56) (0.65)

2001 (0.84) (1.05) (1.25) (1.15)

2002 (0.76) (1.79) (1.03) (1.41)

2003 (0.67) (1.88) (0.67) (1.28)

2004 (0.75) (2.77) (0.26) (1.52)

Debt Service Margin

0.00

2000 2001 2002 2003 2004

(3.00)

(2.50)

(2.00)

(1.50)

(1.00)

(0.50) Pepsi

Coca-Cola

CadburySchw eppes Industry Avg

Given this picture, Coca-Cola is clearly more efficient in providing cash from

operations to cover current notes payables. As shown in the previous section, PepsiCo

has negative performance in this ratio. This is further supported by the fact that PepsiCo

has remained below the industry average throughout most of the five years. This is

clearly adds a negative position in its capital structure.

43


Level II Ratios

Level Two Ratios for PepsiCo

2004 2003 2002 2001 2000

Dividend Payout 0.3155 0.2999 0.3143 0.3737 0.3646

ROE 0.3124 0.3015 0.3581 0.3076 0.3011

SGR 21.38% 21.11% 24.55% 19.26% 19.13%

PepsiCo’s Dividend Payout Ratio decreased from 2001 to 2002 from 0.37 to 0.31

and also from 2002 to 2003 from 0.31 to 0.29. This is not a big decrease for PepsiCo but

it still has a negative impact on the company because it shows that PepsiCo hasn’t had

stable earnings because they are not paying a high portion of earning as dividends. But

from 2000 to 2001 and from 2003 to 2004 the dividend payout ratio has increased from

0.36 to 0.37 and 0.29 to 0.31. This increase shows that PepsiCo has had stable earning

during these years and are more likely to pay a big portion of their earnings as dividend

to their shareholders. PepsiCo has already been able established themselves as a stable

and profitable company throughout the world.

PepsiCo’s Sustainable Growth Rate has been increased from 2000 to 2001 from

19.13 to 19.26, also 2001 to 2002 from 19.26 to 24.55, and from 2003 to 2004 from 21.11

to 21.38. The growth of this rate shows that PepsiCo has been affected by the firms’

ability to improve it ROE. PepsiCo sustainable growth rate also declined only from

2002 to 2003 from 24.55 to 21.11. This probably occurred because of the decline of

dividend payout ratio.

44


Common Size Income Statement for PepsiCo 2004 2003 2002 2001 2000

Sales 100.00% 100.00% 100.00% 100.00% 100.00%

Cost of Goods

Sold 42.00% 41.91% 41.90% 36.52% 34.84%

Amortization 4.32% 4.53% 4.43% 4.02% 4.70%

Gross Income 53.68% 53.56% 53.67% 59.46% 60.46%

Selling & Admin

Expenses 35.20% 35.07% 33.94% 43.10% 44.68%

Income from

Operation 18.49% 18.49% 19.73% 16.37% 15.78%

Interest Expense 0.58% 0.62% 0.72% 0.82% 1.12%

Pretax Income 17.65% 17.31% 18.27% 14.36% 15.07%

Income Taxes 4.69% 5.28% 6.19% 5.08% 5.02%

Net Income 14.39% 13.23% 13.19% 9.88% 10.68%

45


Financial Statements Forecasting

PepsiCo’s fiscal year ends on Dec 31. This company just released to the public

their latest financial statements for 2004. In terms of forecasting PepsiCo’s financial

statements for the next 10 years (Balance Sheet, Income Statement and Statement of Cash

Flow) we used all the financial statements for the past 5 years (Refer to Exhibit A, B

and C). PepsiCo is number two company in the non-alcoholic beverages, currently

behind Coca-Cola, while they are number one in the snack industry due to Frito Lay.

After careful analysis of this company we have concluded that PepsiCo is not affected by

seasonality. Because of this we decided to uses the moving weighted average to forecast

PepsiCo’s financial statements for the next 10 years (Refer to Exhibit AA, BB and CC).

We did this by computing the percentage increase or decrease for each line item

from 2000 to 2004. After getting this percentage we computed the average of these four

numbers to get an expected future change. We then multiplied this number with the 2004

financial statements line to get the forecasted information for 2005. To find 2006, we just

did the same thing, but we didn’t include the percentage increase or decrease from 2000

to 2001 and we included the percentage increase or decrease from 2004 to 2005. We

used the same approach for most of the lines on the Balance Sheet, Income Statement and

Statement of Cash Flow to arrive to the forecasted numbers for each year till the year

2014. For example when we forecasted Total Sales we first found the increase or

decrease from year 2000 to 2001, 2001 to 2002, 2002 to 2003 and 2003 to 2004 which

were 31.7%, -6.8%, 7.4% and 8.4% respectively. Then we find the average which was

10.1% and we multiplied this number with the total sales of 2004 to find the forecasted

number for 2005 which was $32,238 (in millions) So we did the same thing to forecast

2006 but this time we didn’t take the average of the increase from year 2000 to 2001 but

instead we substitute it with the increase from year 2004 to 2005 that we forecasted. And

we multiplied this new average with the forecasted total sale of 2005 to find 2006. We

didn’t use the weighted moving average to calculate the income taxes rate for PepsiCo.

We took the average of the four income tax rate that we founded to be 3% and we

multiplied each year till 2014 with 1.03 to obtain the forecasted income taxes. There was

46


another line that we didn’t use the moving weighted average because of the percentage

increase or decrease during the years. One of these lines was Cash Flow from Investing

Activities. In this line we saw a big decrease from 2001 to 2002 from 2,367 million to

527 million and increase from 2002 to 2003 from 527 million to 2,271 million. This

happened because PepsiCo during 2002 didn’t have any big investment and the increase

in the investment line in the financial statement was very small during this year. This big

decrease and increase would have caused our future Cash Flow from Investing Activities

not be forecasted in a smooth way. So the forecast for this line was not going to have a

normal growth in the next 10 years. Instead to forecast this number we just measured the

percentage increase from 2003 to 2004 and we calculated a growth of 8%. After that we

multiplied this line with 1.08 to find the Cash Flow from Investing Activities for the next

10 years.

Based on our forecast we conclude that PepsiCo is going to have a steady growth

during the next 10 years. The firm has the potential for growth in the next years and

history has shown this trait. PepsiCo used to own Pizza Hut and Taco Bell but they

didn’t realize any profit on their acquisition, so they decided to sell them. This has been

shown as a good decision for the company for the future. But at the same time, they have

made some good decision by acquiring good company like Gatorade and Frito Lay that

have good profits and sales. So our forecasted financial statements are free of errors and

we don’t assume that our forecast it is going to be accurate. The longer the period of the

forecast the less accurate the forecast will be and the past economic practices have shown

this. PepsiCo can buy other bad companies like Pizza Hut and Taco Bell and this is

going to decrease their reputation and decrease their net income. Maybe during the next

10 years they can win the war against Coke and increase their global reputation. Another

reason that PepsiCo will not perform as forecasted is if there is the change of economic

fluctuations. For example the decrease of the economy or the decrease of the value of the

dollar may turn the growth of sales the other way around. Competition is another reason

that PepsiCo might not perform as forecasted. During the next 10 years other companies

can surge and gain more market share in the non-alcoholic beverage. This is going to

decrease the market share for PepsiCo and decrease their sales and reputation as well.

47

Valuation Analysis

IV Valuation Analysis

The valuation process is of importance since this is integrated into every aspect of

the economy. The financial market is highly dependent on such valuations since this

represents much of the underlining activities. Investment companies use such tactics to

value other firms; Insurance companies utilize such information to make sure they have

enough money to cover certain events. Also this information is important to retirement

programs, since companies want to make sure that they can cover current pension benefit

obligations. Finally, this is important for such things as IPO’s, firm takeovers, and

investment decisions.

The purpose of this section is to value PepsiCo Inc. We achieved this by

considering risk and by calculating how much of the firm is financed with debt and

equity. Valuation is the process of converting the forecast for a company into an estimate

of the value of the firm or some component of the firm. We used six different models to

value PepsiCo, which include the following: method of comparables, discounted free

cash flows, discounted dividends, discounted residual income, abnormal earning growth,

and long run average residual income perpetuity based on the P/B ratio. All of these

models helped us to find if the share price of PepsiCo is overvalued, undervalued, or

reasonably valued.

Method of Comparables Valuation:

This section is going to value PepsiCo by using the average multiple of

competitors in the industry. The ratios used are price to book, price to earnings, dividend

to price, price to sales, and price earning growth (PEG). These multiple models were the

simplest to implement since forecasted numbers are not necessary in the calculations.

48

Valuation Analysis

PepsiCo currently has two direct competitors in the industry, which are Coca-Cola and

Cadbury Schweppes. Due to the fact that PepsiCo only has two main competitors, we

found that it would be unnecessary to trim down the averages calculated below. Also,

since these three competitors represent the majority of the industry, we felt it necessary to

use both in our calculations. From our calculations we found that the price-earning

multiple and the PEG multiple were the best estimation the PepsiCo’s price since they

were both at $48.92 and $50.80 respectively compared to the actual stock price of

$52.76. The trailing P/E ratio yielded a higher price, which is based of the current

published P/E ratios. We decided to focus on the forecasted ratio since this section

focuses on forecasted numbers. The market to book value indicated a smaller price at

$37.07. Cadbury Schweppes could have been considered an outlier, but do to the

relatively small sample of competitors and the fact that the average just would have been

Coca-Cola’s number; we utilized their value as well. If we did trim off Cadbury

Schweppes, the estimated price would have been much in line of the actual price at

$52.73. The dividend yield also revealed a lower price at $39.72. This may have been

due to the fact that PepsiCo doesn’t declare dividends as much as competitors, as well as

support PepsiCo’s higher growth. This would seemingly indicate why it would have a

lower value. The price to sales multiple indicated a higher price relative to the actual

price. This is due to the fact that Coca-Cola pays out more than any other company

having a direct affect on the average, which would achieve this higher price of $57.38. In

actuality, PepsiCo has a lower price to sales ratio, which would indicate that it pays out

less then the industry average. This would conclude a much higher price than actually

would occur. The reason for not trimming Cadbury Schweppes in the model was the fact

that only including Coca-Cola would result in even a higher estimated price. (See

EXHIBIT 4)

Although these models are simple to implement and calculate, they are only

estimates based on the industry averages. Some discrepancies can and have occurred in

the estimation of our prices. Our sample size was relatively small, only having three

main competitors. Trimming the competitors would have a negative affect on these

averages, only representing one company. Based on whether this company was above or

below the industry norm would have a negative effect on our calculations. Also since

49

Valuation Analysis

outliers were not eliminated, true representation of the averages could have been affected

as well as in the case of the P/S and P/B averages, in which case Cadbury Schweppes

could have been possible outliers.

EXHIBIT 4

Method of Comparables

2005 EPS BPS DPS PPS SPSPepsiCo 2.55 8.15 0.98 52.76 18.90Coca-Cola 2.05 6.40 1.08 41.38 9.40Cadbury S 2.20 15.20 0.93 40.00 23.95

P/E Ratio (PPS/EPS)PepsiCo 20.69 (Not Included in Average)Coca-Cola 20.19Cadbury S 18.18

Avg 19.18Price 48.92

P/B Ratio (PPS/BPS)PepsiCo 6.47 (Not Included in Average)Coca-Cola 6.47Cadbury S 2.63

Avg 4.55Price 37.07

Dividend Yield (DPS/PPS)PepsiCo 0.02 (Not Included in Average)Coca-Cola 0.03Cadbury S 0.02

Avg 0.025Price 39.72

P/S Ratio (PPS/SPS)PepsiCo 2.79 (Not Included in Average)Coca-Cola 4.40Cadbury S 1.67

Avg 3.04Price 57.38

PEG RatioPepsiCo 1.88 (Not Included in Average)Coca-Cola 2.17Cadbury S 2.20

Avg 2.19Price 50.80

50

Valuation Analysis

Discounted Free Cash Flow Model

The first intrinsic valuation model used to value PepsiCo was the discounted free

cash flow model. To use this model we need to calculate the weighted average cost of

capital (WACC) in which our cost of equity (Ke) and cost of debt (Kd) will be found.

We derived the cost of capital (Ke) by using historical data over the past 60 months of the

return on the market (Rm) of the S&P 500, and the risk-free rate (Rf) of the T-Bill returns

for 5 years. To find the beta for our company we used the regression analysis using the

percentage return of the firm (Y-variable) and the market spread (X-variable) data from

the past 61 months (April 1 2000 – April 1 2005). With this analysis we found an

estimated beta for the company equaling 0.32. (See Exhibit 1). We believe that this beta

is low comparing it with the published beta of 0.65 (Value Line). We also founded the

estimated beta for the past 2 and 3 years, which were 0.48 and 0.76 respectively.

We calculated the CAPM (Ke) by using the estimated beta for 5 years, 3 years, 2

years and the published beta. The CAPM (Ke) equaled 2.57%, 5.65%, 3.69% and 4.88%

respectively. We believe that the Ke of 4.88% found using the published beta represent

PepsiCo better that any other beta. Formulating the WACC was the next valuation step.

To find the WACC we first had to find the (Kd). We calculated (Kd) by using the

balance sheet notes for 2004 to find the Weighted Average Cost of Debt. (See Exhibit 2).

We then found the value of equity of the firm by multiplying the firms PPS with the share

outstanding. Also, we then found the value of the debt of the firm by finding the sum of

the current maturity of long debt with the long-term debt. (See Exhibit 3).

By implementing these numbers, the value of equity equals to

$52.76*1,687,000,000 shares outstanding =$89,006,120,000 and the value of debt is

equal to $2,397,000,000 + $1,054,000,000 = $3,451,000,000. The value of the firm is

equal to the value of debt (Vd) + value of equity (Ve). By plugging into the equation the

value of firm (Vf) is equal to $92,457,120,000. Now we have the entire components to

51

Valuation Analysis

find WACC. We found the firm’s tax rate by finding the average of the firm’s tax rate

for the previous five years. The average calculated tax rate was 31.66%. (See Exhibit 3).

To find the WACC we did the following calculation:

WACC=(3451000000/92457120000)*(0.0398)*(1- .166) +

(89006120000/92457120000)*(0.0488). We calculated a WACC of 4.8%.

Using the WACC calculated above, we performed the discounted free cash flow.

Next, we used and implied a growth rate of 2% after 2014 for the Free Cash Flow to the

Firm. Our analysis found an estimated price of $47.90. Comparing the estimated price

with the actual price of $52.76 we think that PepsiCo is slightly overvalued. This is

reasonable to infer since the actual price is bigger than that of our estimated price. We

also performed a sensitivity analysis for this model. During this analysis we founded a

high amount of sensitivity. For example if the firm had no growth after 2014 in the free

cash flow to the firm the estimated price was going to be $30.85; but if we had a higher

growth of 0.04 the estimated price was going to be $150.21. This is a very high price

because the difference between WACC and growth is very small. This number is

probably very unrealistic. The sensitivity analysis shows that a change in WACC without

a corresponding change in growth and vice versa will change the estimated price greatly

compared to the actual price. (See Exhibit 5).

Sensitivity Analysis

g

0 0.01 0.02 0.04

WACC 0.02 $81.45 $154.56 N/A N/A

0.03 $52.46 $74.78 $141.75 N/A

0.048 $30.85 $37.13 $47.90 $150.21

0.06 $23.71 $27.15 $32.32 $58.18

52

Valuation Analysis

Discounted Dividend Model

The other valuation model that we used was the Discounted Dividend Model.

(See Exhibit 6). The discounted dividend model was performed using a new (Ke) that

we found from the discounted free cash flow model by using the WACC formula. This

new Ke that we found was equal to 4.84%. To forecast the dividend per share for the

next 10 years we used the moving weighted average like of that in our forecast. We

assumed that after 2014 dividend per share would be $2.23 with no growth. This model

gave us a price of $43.18. Comparing this price with the actual price $52.76 we still

think that PepsiCo is still overvalued.

The discounted dividend model has the highest sensitivity to change compared

with the other models. In the sensitivity analysis we used the new Ke and the (Ke) that

we found for the estimated beta for 5 and 3 years. For example if we had a growth of 2%

after 2014 the estimated price was going to be $65.53. On the other hand if we used the

(Ke)=0.0257 that we found by using the estimated beta for 5 years with no growth and

with 0.01 growth after 2014 the estimated price was going to be $70.79 and $108.71

respectively. This shows a very big change and unrealistic prices for PepsiCo. The

primary reason for these high prices is because our firm has a low (Ke). Also, we see in

the sensitivity analysis that if we have a high (Ke) like 0.056 with no growth or a growth

of 2% the prices are going to be $38.91 and $54.02 respectively. Since this model has the

highest sensitivity to change compared to other models we believe that the estimated

price of $43.18 doesn’t represent the fundamental value of PepsiCo stock price in April 1,

2005.

53

Valuation Analysis

Sensitivity Analysisg

0 0.01 0.02 0.05

Ke 0.02 $87.86 $164.01 N/A N/A0.0257 $70.79 $108.71 $278.90 N/A0.0484 $43.18 $51.37 $65.53 N/A0.056 $38.91 $44.82 $54.02 $265.540.07 $33.47 $37.09 $42.17 $87.86

Discounted Residual Income Model

The next model that we used to value PepsiCo was the Discounted Residual

Income Model. In the discounted residual income model, we analyzed a stream of

residual incomes from the next 10 years, including a terminal value, and we then

discounted all the numbers back to the present time. (See Exhibit 7). To find the book

value for the next 10 years we used the same method that we used in our forecast. We

used the moving weighted average. We begin this model by finding the ending book

value of equity which we found by adding the book value of equity with the earning per

share, and then subtracting the dividends per share. Then, we found the Normal Income

by multiplying (Ke) with the beginning book value of equity from the previous years.

The difference between earnings per share and normal income is the residual income.

After that we calculate perpetuity of the continuing terminal value based on a growth that

is going to be variable in the sensitivity analysis. We assumed that after 2014 Residual

Income would be 1.91 with no growth. The residual income is then discounted back to

the present time. To find the estimated value per share we add the book value equity for

54

Valuation Analysis

2005, with the present value of residual income in 2005, and also with the present value

of terminal value in 2005. By using a (Ke) of 4.84% and assuming no growth after 2014,

this model gives us a price of $51.80 which is very close to the actual price of $52.76.

But by comparing the actual price with the estimated price we see that the firm is

overvalued slightly.

The discounted residual income model has a moderate sensitivity to changes in

cost of equity and growth. We can see this in the sensitivity analysis of this model. For

example is we have a growth after 2014 of 1% the estimated price is going to be $58.85,

but if we increase the (Ke) and use the one that we calculated by our estimated beta for 3

years we and still 1% growth, the price of the stock is going to be $48.92. From the

sensitivity analysis we learned that the estimated price per share is much more sensitively

to changes in cost of equity than to changes in the growth rate. For example if we use the

cost of equity( Ke) 2.57% that we found by using the beta estimated for 5 years with no

growth, we have an estimated price per share of $100. If we compare this number with

the estimated price per share that we found using (Ke) of 4.84% with no growth that is

$51.80 we see a big difference. This is a very high number because the cost of equity is

very low.


g

0 0.01 0.02 0.05

Ke 0.02 $129.53 $230.53 N/A N/A

0.0257 $100.00 $146.01 $353.42 N/A

0.0484 $51.80 $58.85 $70.79 N/A

0.056 $44.45 $48.92 $55.88 $215.86

0.07 $35.07 $37.23 $40.24 $67.37

55

Valuation Analysis

Long Run Average Residual Income Based on the P/B Ratio

This model is based off the estimations in the Residual Income model addressed

in the previous section. By allowing PepsiCo to grow over an infinite life, we can solve

for values based off of the perpetuity. This model can also compare different results of

prices by implementing different cost of equities and growth rates into the equation.

(a) Exhibit 9

(b) P= BE + BE[ROE-Ke]/[Ke-G]

(i) Sensitivity Analysis

g

0 0.01 0.02 0.05

Ke 0.02 $127.30 $246.46 N/A N/A

BE 8.15 0.0257 $99.07 $156.98 $418.08 N/A

ROE 0.3124 0.0484 $52.60 $64.18 $83.91 N/A

0.056 $45.47 $53.58 $66.20 $356.43

0.07 $36.37 $41.08 $47.66 $106.93

56

Valuation Analysis

The current book value of equity for PepsiCo is 8.15, which is much smaller than

Cadbury’s 15.20 and slightly larger than Coca-Cola’s of 6.40. We also found PepsiCo’s

ROE of .3124 from the forecasting section. Given different scenarios of Ke and growth,

we were able to derive different prices based on the information. In the Residual Income

section we discovered that a cost of equity of 4.84 achieved a price of $51.80, which was

slightly less than the actual current price. Consistent with this valuation, the price of the

perpetuity at a growth rate of zero and a Ke of 4.84 was considerably close as well at

$52.60. Also examining the Ke of 2.57, which was calculated using the estimated beta

and risk free interest rate, yield a much higher price of $127.30. This would infer that the

PepsiCo is undervalued by 74 dollars. This result could have been the result of the

estimated beta previously described. By assuming growth in this equation, it revealed

that a cost of equity of 5.6 and a growth of 1% calculated a price of $53.58, which is

slightly above the current price. Also by assuming a Ke of 7% and a growth of 2%

revealed a price of $47.66. By looking at these assumptions it may infer that PepsiCo is

slightly overvalued.

By examining the sensitivity analysis above, can give a clear picture of the effect

on price based on changes on cost of equity and growth assumptions. Only by predicting

a fairly accurate estimate of cost of equity will give a fairly accurate assumption of the

price. This model is also fairly easy to implement and easy to understand. The only

downside to this model is the estimation of the cost of equity and growth. It is very hard

to believe that our Ke estimation of 4.84% is entirely accurate since this reflects a growth

rate of zero, which is hard to believe. This in conclusion, it could be fair to assume that

the Ke could be in the range of 5.6% to 7% based on the growth rates of 1 and 2%

.

Abnormal Earning Growth Model

The AEG model takes into consideration the present value of the investment

opportunities of the dividend paid to the shareholders. (See Exhibit 8). This model does

not only include the dividend payment themselves, but it implies that they are included in

57

Valuation Analysis

the earnings per share. The value of the investment opportunities, assuming that you are

going to invest at the current cost of equity, is also part of the model. The Abnormal

earnings are calculated by subtracting the cum-dividend earnings with the normal

earnings. These abnormal earnings are then discounted back to the present time. We

then set up perpetuity of AEG for the firm to find the value of each share. In our case we

assumed that after 2014 the AEG will be 0.023 with no growth. We still used the cost of

equity of 4.84% and this model gave us a price per share of $54.13. This is the first

model that shows that the company is undervalued because all the other models showed

that our company as overvalued. This model requires a very accurate cost of equity

because many components of the model are affected by it. For example as we see on the

sensitivity analysis for this model if we used the cost of equity estimated by using the five

year beta that is 2.57% with no growth the price per share is $74.36. The change of the

growth doesn’t make big changes and we see this if we had a growth after 2014 of 1 % or

2% with a cost of equity of 4.84% the price per share was going to be $55.9 and $58.93

respectively. We believe that our estimated cost of equity of 4.84% that we found by

using the WACC formula with the numbers taken from the discounted free cash flow

model is very accurate.


g

0 0.01 0.02 0.05

Ke 0.02 $86.18 $120.47 N/A N/A

0.0257 $74.36 $89.31 $156.69 N/A

0.0484 $54.13 $55.90 $58.93 N/A

0.056 $50.81 $51.80 $53.35 $88.87

0.07 $46.41 $46.74 $47.12 $51.34

58

Valuation Analysis

Discussion and Summary of Overall Results:

In all of our valuation models except abnormal earning growth model, the actual

price exceeded our estimated price. We believe that the abnormal earning growth model

is not a very accurate model because just the word abnormal means that something is not

normal. We think that this model doesn’t represent the fundamental value of PepsiCo

stock price in April 1, 2005.

By computing the average of the difference between estimated price and the

actual price from our entire valuation models we determined that the stock price of

PepsiCo is overvalued by an average of $3.51 per share. The residual income model was

the model that come the closest to the price of the stock on April 1, 2005. The difference

between the actual price per share and the estimated price per share in this model was 96

cents overvalued. We feel that the discounted dividend model is the least accurate

because it showed that the stock price of PepsiCo as April 1, 2005 is $9.58 overvalued

compared to the estimated price per share that this model estimated. If we don’t consider

this model the stock price of PepsiCo is overvalued only by an average of $1.48 per

share. Throughout most of these models the change of the growth rate was the most

sensitive factor of change, besides the discounted residual income where the cost of

equity was very sensitive to the change of the price per share.

59

Appendix

V Appendix

Exhibit A Income Statement for PepsiCO

5 YR ANNUAL INCOME STATEMENT 12/31/2004 12/31/2003 12/31/2002 12/31/2001 12/31/2000Sales 29,261.00 26,971.00 25,112.00 26,935.00 20,438.00

Cost of Goods Sold 12,289.00 11,303.00 10,523.00 9,837.00 7,121.00Depreciation, Depletion & Amortization 1,264.00 1,221.00 1,112.00 1,082.00 960

Gross Income 15,708.00 14,447.00 13,477.00 16,016.00 12,357.00Selling, General & Admin Expenses 10,299.00 9,460.00 8,523.00 11,608.00 9,132.00

Total Operating Expenses 23,852.00 21,984.00 20,158.00 22,527.00 17,213.00

Operating Income 5,409.00 4,987.00 4,954.00 4,408.00 3,225.00

Extraordinary Charge - Pretax 150 206 224 387 0

Non-Operating Interest Income 74 51 36 67 76

Earnings Bef Interest & Taxes 5,333.00 4,832.00 4,766.00 4,088.00 3,301.00

Interest Expense on Debt 169 167 181 222 228

Interest Capitalized 2 4 3 3 7

Pretax Income 5,166.00 4,669.00 4,588.00 3,869.00 3,080.00

Income Taxes 1,372.00 1,424.00 1,555.00 1,367.00 1,027.00

Equity Interest Earnings 380 323 280 160 130

4,212.00 3,568.00 3,313.00 2,661.00 2,183.00

Preferred Dividends 3 3 4 4 0Net Income Bef Preferred Dividends 4,212.00 3,568.00 3,313.00 2,661.00 2,183.00Preferred Dividend Requirements 3 3 4 4 0Net Income Available To Common 4,212.00 3,568.00 3,312.00 2,660.00 2,183.00

Income Statement for Pepsi Co provided by Thomson Analytics for Accounting (Amounts In Millions)

Net Income Bef Extraordinary Items & Disc Ops

60

Appendix

Exhibit B Balance Sheet for PepsiCo

5 YR ANNUAL BALANCE SHEET 12/31/2004 12/31/2003 12/31/2002 12/31/2001 12/31/2000

AssetsCash & Equivalents 3,445.00 2,001.00 1,845.00 1,649.00 1,330.00

Receivables Net 2,999.00 2,830.00 2,531.00 2,142.00 1,799.00

Inventories 1,541.00 1,412.00 1,342.00 1,310.00 905

Other Current Assets 654 687 695 641 570

Total Current Assets 8,639.00 6,930.00 6,413.00 5,853.00 4,604.00Investments in Unconsol Subsidiaries 3,284.00 2,920.00 2,611.00 2,871.00 2,978.00Property, Plant & Equipment - Gross 15,930.00 14,755.00 13,395.00 12,180.00 9,539.00

Accumulated Depreciation 7,781.00 6,927.00 6,005.00 5,304.00 4,101.00Property, Plant & Equipment - Net 8,149.00 7,828.00 7,390.00 6,876.00 5,438.00

Other Assets 7,915.00 7,649.00 7,060.00 6,095.00 5,319.00

Total Assets 27,987.00 25,327.00 23,474.00 21,695.00 18,339.00

LiabilitiesAccounts Payable 1,731.00 1,638.00 1,543.00 1,238.00 1,000.00ST Debt & Current Portion Due LT Debt 1,054.00 591 562 354 72

Accrued Payroll 961 851 806 789 673

Income Taxes Payable 99 611 492 183 48

Dividends Payable 387 274 259 255 202Other Current Liabilities 2,520.00 2,450.00 2,390.00 2,179.00 1,940.00

Total Current Liabilities 6,752.00 6,415.00 6,052.00 4,998.00 3,935.00

Long Term Debt 2,397.00 1,702.00 2,187.00 2,651.00 2,346.00

Deferred Taxes 1,216.00 1,261.00 1,718.00 1,496.00 1,361.00

Other Liabilities 4,099.00 4,075.00 4,226.00 3,876.00 3,448.00

Total Liabilities 14,464.00 13,453.00 14,183.00 13,021.00 11,090.00

Shareholders' EquityPreferred Stock 41 41 41 26 0

Common Equity 13,482.00 11,833.00 9,250.00 8,648.00 7,249.00Total Liabilities & Shareholders' Equity 27,987.00 25,327.00 23,474.00 21,695.00 18,339.00

Balance Sheet for Pepsi Co provided by Thomson Analytics for Accounting (Amount in Millions)

61

Appendix

62

Exhibit C Statement of Cash Flow for PepsiCo

5 YEAR ANNUAL CASH FLOW STATEMENT 12/31/2004 12/31/2003 12/31/2002 12/31/2001 12/31/2000

Operating ActivitiesIncome Bef Extraordinary Items 4,212.00 3,568.00 3,313.00 2,661.00 2,183.00Depreciation, Depletion & Amortization 1,264.00 1,221.00 1,112.00 1,082.00 960

Investment Tax Credit 17 -323 288 162 63Other Cash Flow -126 -63 -399 212 187

Funds From Operations 5,367.00 4,403.00 4,314.00 4,117.00 3,393.00Funds From/For Other Operating Activities -313 -75 313 84 518Net Cash Flow From Operating Activities 5,054.00 4,328.00 4,627.00 4,201.00 3,911.00

Investing Activities

Capital Expenditures 1,387.00 1,345.00 1,437.00 1,324.00 1,067.00

Increase In Investments 1,071.00 1,052.00 427 3,010.00 4,643.00

Decrease In Investments 38 31 833 2,078.00 4,171.00

Disposal of Fixed Assets 38 49 89 0 86Other Use/(Source) - Investing 52 46 415 n/a 260

Net Cash Flow From Investing Activities 2,330.00 2,271.00 527 2,637.00 1,713.00Financing ActivitiesCom/Prf Purchased,Retired,Converted,Redeemed 3,055.00 1,945.00 2,190.00 1,731.00 1,430.00

Long Term Borrowings 504 52 11 324 130Inc(Dec) In ST Borrowings 1,112.00 13 -62 -92 34Reduction In Long Term Debt 512 641 353 573 795

Cash Dividends Paid - Total 1,329.00 1,070.00 1,041.00 994 796

Net Cash Flow From Financing Activities -2,315.00 -2,902.00 -3,179.00 -1,919.00 -2,298.00

Exchange Rate Effect 51 27 34 n/a n/aCash & Cash Equivalents - Inc(Dec) 460 -818 955 -355 -100

Cash Flow for PepsiCo provided by Thomson Analytics for Accounting (Amounts In Millions)

Appendix

Exhibit AAINCOME STATEMENT FOR PEPSICO (Amounts in millions of dollars)

Current Years Forecasted Years

Years 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Total Sales 20,438 26,935 25,112 26,971 29,261 32,238 33,796 36,499 39,054 41,788 44,713 47,843 51,192 54,775 58,609

Cost of Good Sold 7,121 9,837 10,523 11,303 12,289 14,132 15,545 17,099 18,809 20,690 22,759 25,035 27,538 30,292 33,321

Amortization 960 1,080 1,112 1,221 1,264 1,365 1,447 1,548 1,641 1,739 1,844 1,954 2,072 2,196 2,328

Gross Income 12,357 16,016 13,477 14,447 15,708 16,741 16,804 17,852 18,604 19,359 20,110 20,854 21,582 22,287 22,961

Selling,Adm Expense 9,132 11,608 8,523 9,460 10,299 10,814 10,706 11,241 11,690 12,040 12,401 12,773 13,156 13,551 13,958

Earning Bef Interest&Taxes 3,301 4,088 4,766 4,832 5,333 5,927 6,098 6,611 6,914 7,319 7,709 8,081 8,426 8,736 9,003

Interest expense 228 222 181 167 169 157 144 135 128 120 113 106 100 94 88

Pretax Income 3,080 3,869 4,588 4,669 5,166 5,770 5,954 6,476 6,786 7,199 7,596 7,975 8,326 8,643 8,915

Income Taxes 1,027 1,367 1,555 1,424 1,372 1,413 1,456 1,499 1,544 1,591 1,638 1,687 1,721 1,773 1,826

Net Income 2,183 2,660 3,312 3,568 4,212 4,357 4,498 4,977 5,242 5,608 5,958 6,287 6,605 6,870 7,089

63

Appendix

Exhibit BBBALANCE SHEET FOR PEPSICO (Amounts in millions of dollars)


Years 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Cash Equivalent 1,330 1,649 1,845 2,001 3,445 4,437 5,768 6,114 6,603 7,065 8,479 10,174 11,192 13,430 16,116

Receivable Net 1,799 2,142 2,531 2,830 2,999 3,388 3,794 4,173 4,590 4,820 5,301 5,832 6,123 6,735 7,409

Inventory 905 1,310 1,342 1,412 1,541 1,623 1,720 1,823 1,914 2,010 2,110 2,216 2,326 2,443 2,565

Total Current Asset 4,034 5,101 5,718 6,243 7,985 9,448 11,282 12,110 13,107 13,895 15,890 18,222 19,641 22,608 26,090

Investments 2,978 2,871 2,611 2,920 3,284 3,378 3,667 3,850 4,120 4,532 4,305 4,564 4,929 4,732 5,001

Gross Property Plant&Equ 9,539 12,180 13,395 14,755 15,930 18,142 19,938 21,513 24,482 26,930 28,546 32,485 35,701 38,200 43,472

Accumulated Depreciation 4,101 5,304 6,005 6,927 7,781 9,104 10,224 11,450 12,733 14,936 16,907 18,987 21,835 24,520 27,536

Net Property Plant&Equ 5,438 6,876 7,390 7,828 8,149 9,006 9,366 10,022 10,523 11,154 11,601 12,819 13,716 13,990 14,690

Other Assets 5,319 6,095 7,060 7,649 7,915 8,725 8,987 9,706 10,696 11,230 11,567 12,129 12,614 13,497 14,037

Total Asset 18,339 21,695 23,474 25,327 27,987 30,995 33,474 36,151 39,404 42,556 45,876 50,005 53,230 57,488 62,662

Account Payable 1,000 1,238 1,543 1,638 1,731 1,973 2,209 2,407 2,647 2,912 3,145 3,459 3,805 4,109 4,520

Other Current Liabilities 1,940 2,179 2,390 2,450 2,520 2,691 2,766 2,836 2,921 3,029 3,319 3,545 3,971 4,026 4,187

Total Current Liabilities 3,935 4,998 6,052 6,415 6,752 7,697 8,543 9,226 10,056 10,860 11,729 12,668 13,681 14,912 16,105

Long Term Debt 2,346 2,651 2,187 1,702 2,397 2,476 2,105 2,399 2,087 1,879 2,893 3,125 3,562 2,992 3,710

Other Liabilities 3,448 3,876 4,226 4,075 4,099 4,279 4,309 4,783 4,496 4,721 5,051 5,607 5,775 5,255 5,571

Total Liabilities 11,090 13,021 14,183 13,453 14,464 15,331 15,790 16,105 16,749 17,369 17,890 18,426 19,108 19,586 20,311

Total Shareholder Equity 7,249 8,648 9,250 11,833 13,482 15,664 17,684 20,046 22,655 25,188 27,986 31,578 34,122 37,902 42,352

64

Appendix

65

Exhibit CCCASH FLOW FOR PEPSICO (Amounts in millions of dollars)


Years 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Income Bef Extraordinary 2,183 2,661 3,313 3,568 4,212 4,955 5,351 5,887 6,946 7,293 7,585 8,116 9,090 9,726 10,407

Depreciation&Amortization 960 1,082 1,112 1,221 1,264 1,352 1,406 1,547 1,670 1,771 1,850 1,906 2,001 2,141

Funds From Operations 3,393 4,117 4,314 4,403 5,367 6,024 6,325 6,610 7,337 7,850 8,533 9,011 9,282 9,746 10,214

Cash Flow OP Activities 3,911 4,201 4,627 4,328 5,054 5,357 5,678 5,961 6,437 6,887 7,300 7,738 8,203 8,613

Capital Expenditures 1,067 1,324 1,437 1,345 1,387 1,486 1,534 1,442 1,499 1,604 1,732 1,784 1,695 1,831

Increase in Investments 4,643 3,010 427 1,052 1,071 1,142 959 1,065 1,150 966 811 974 1,052 1,199

Cash Flow INV Activities 1,713 2,637 527 2,271 2,330 3,261 4,040 4,242 4,581 4,810 5,099 5,303 5,674 6,071

Com/Prf Redeemed 1,430 1,731 2,190 1,945 3,055 3,768 3,316 3,714 4,605 5,250 4,620 5,682 5,114 5,881

Cash Dividend Paid 796 994 1,041 1,070 1,329 1,513 1,574 1,658 1,874 1,927 2,194 2,297 2,412 2,702

Cash Flow Fin Activities -2,298 -1,919 -3,179 -2,902 -2,315 -2,429 -2,179 -1,991 -2,787 -2,926 -2,458 -2,311 -3,928 -3,300

2014

2,216

9,129

1,922

959

6,193

7,116

2,864

-2,772

Appendix

EXHIBIT 1

Date Adj. Price

Price Return

Adj. Price

S&P 500 Return

T-Bill return

(Rm - Rf)

1 4/1/05 52.76 -0.51% 1172.92 -0.65% 0.32% -0.97% 2 3/1/05 53.03 -1.12% 1180.59 -1.91% 0.31% -2.22% 3 2/1/05 53.63 0.30% 1203.6 1.89% 0.31% 1.58% 4 1/3/05 53.47 2.87% 1181.27 -2.53% 0.31% -2.84% 5 12/1/04 51.98 5.07% 1211.92 3.25% 0.30% 2.95% 6 11/1/04 49.47 0.67% 1173.82 3.86% 0.29% 3.57% 7 10/1/04 49.14 1.91% 1130.2 1.40% 0.28% 1.12% 8 9/1/04 48.22 -2.27% 1114.58 0.94% 0.28% 0.66% 9 8/2/04 49.34 0.00% 1104.24 0.23% 0.29% -0.06%

10 7/1/04 49.34 -7.19% 1101.72 -3.43% 0.31% -3.74% 11 6/1/04 53.16 1.37% 1140.84 1.80% 0.33% 1.47% 12 5/3/04 52.44 -2.05% 1120.68 1.21% 0.32% 0.89% 13 4/1/04 53.54 1.19% 1107.3 -1.68% 0.28% -1.96% 14 3/1/04 52.91 4.07% 1126.21 -1.64% 0.23% -1.87% 15 2/2/04 50.84 9.81% 1144.94 1.22% 0.26% 0.97% 16 1/2/04 46.3 1.38% 1131.13 1.73% 0.26% 1.47% 17 12/1/03 45.67 -2.79% 1111.92 5.08% 0.27% 4.80% 18 11/3/03 46.98 0.62% 1058.2 0.71% 0.27% 0.44% 19 10/1/03 46.69 4.36% 1050.71 5.50% 0.27% 5.23% 20 9/2/03 44.74 3.25% 995.97 -1.19% 0.27% -1.46% 21 8/1/03 43.33 -3.32% 1008.01 1.79% 0.28% 1.51% 22 7/1/03 44.82 3.53% 990.31 1.62% 0.24% 1.38% 23 6/2/03 43.29 1.05% 974.51 1.13% 0.19% 0.94% 24 5/1/03 42.84 2.12% 963.59 5.09% 0.21% 4.88% 25 4/1/03 41.95 8.20% 916.92 8.10% 0.24% 7.86% 26 3/3/03 38.77 4.78% 848.18 0.84% 0.23% 0.60% 27 2/3/03 37 -5.32% 841.15 -1.70% 0.24% -1.94% 28 1/2/03 39.08 -4.12% 855.7 -2.74% 0.25% -3.00% 29 12/2/02 40.76 -0.27% 879.82 -6.03% 0.25% -6.29% 30 11/1/02 40.87 -3.68% 936.31 5.71% 0.25% 5.45%

31 10/1/02 42.43 19.35% 885.77 8.64% 0.25% 8.40%

32 9/3/02 35.55 -6.20% 815.29 -11.00% 0.25% -

11.25% 33 8/1/02 37.9 -7.90% 916.07 0.49% 0.27% 0.21% 34 7/1/02 41.15 -10.91% 911.62 -7.90% 0.32% -8.22% 35 6/3/02 46.19 -7.01% 989.81 -7.25% 0.35% -7.60% 36 5/1/02 49.67 0.16% 1067.14 -0.88% 0.37% -1.26% 37 4/1/02 49.59 0.77% 1076.64 -6.17% 0.39% -6.55% 38 3/1/02 49.21 2.27% 1147.39 3.67% 0.40% 3.28%

66

Appendix

67

39 2/4/02 48.12 0.84% 1106.73 -2.08% 0.36% -2.43% 40 1/2/02 47.72 2.87% 1130.2 -1.56% 0.36% -1.92% 41 12/3/01 46.39 0.41% 1148.08 0.76% 0.37% 0.39% 42 11/1/01 46.2 -0.15% 1139.45 7.60% 0.33% 7.26% 43 10/1/01 46.27 0.43% 1059.01 1.74% 0.33% 1.41% 44 9/4/01 46.07 3.50% 1040.94 -8.17% 0.34% -8.52% 45 8/1/01 44.51 0.79% 1133.58 -6.41% 0.38% -6.79% 46 7/2/01 44.16 5.49% 1211.23 -1.08% 0.40% -1.47% 47 6/1/01 41.86 -0.92% 1224.42 -2.50% 0.40% -2.90% 48 5/1/01 42.25 2.47% 1255.82 0.51% 0.41% 0.10% 49 4/2/01 41.23 -0.63% 1249.46 7.68% 0.40% 7.28% 50 3/1/01 41.49 -4.33% 1160.33 -6.42% 0.39% -6.81% 51 2/1/01 43.37 4.56% 1239.94 -9.23% 0.41% -9.64% 52 1/2/01 41.48 -11.06% 1366.01 3.46% 0.41% 3.06% 53 12/1/00 46.64 9.56% 1320.28 0.41% 0.43% -0.03% 54 11/1/00 42.57 -6.32% 1314.95 -8.01% 0.48% -8.48% 55 10/2/00 45.44 5.31% 1429.4 -0.49% 0.48% -0.98% 56 9/1/00 43.15 8.23% 1436.51 -5.35% 0.49% -5.84% 57 8/1/00 39.87 -6.93% 1517.68 6.07% 0.51% 5.56% 58 7/3/00 42.84 3.10% 1430.83 -1.63% 0.52% -2.15% 59 6/1/00 41.55 9.57% 1454.6 2.39% 0.53% 1.87% 60 5/1/00 37.92 10.91% 1420.6 -2.19% 0.56% -2.75% 61 4/3/00 34.19 1452.43 Average 0.33% BETA INTERCEPT R^2 0.32 0.01055 0.06781 Cost of Equity (Estimated Beta) 2.57% Ke = Rf + B(Rm - Rf) Ke = 0.33% + 0.32(7%) Cost of Equity (Published Beta) 4.88% Ke = Rf + B(Rm - Rf) Ke = 0.33% + 0.65(7%) BETA 2 years 3 years 0.48 0.76 Ke 3.69% 5.65%

Appendix

Exhibit 2PEPSICO 10-K 2004/12/25: Balance Sheet

LIABILITIES 12/25/2004 (Percent of Total Liabilities Computed Interest Rate Value Weighted RateCurrent Liabilities: Accounts payable $1,731 11.97% 0.00% 0.00% Current portion of long-term debt $1,054 7.29% 6.01% 0.44% Notes payable $0 0.00% 0.00% 0.00% Other current liabilities $2,520 17.42% 4.38% 0.76% Total Current Liabilities $6,752 46.68%Long-term Debt $2,397 16.57% 6.01% 1.00%Deferred Income Taxes $1,216 8.41% 0.00% 0.00%Other Liabilities $4,099 28.34% 6.30% 1.79%

Total Non-Current Liabilities $7,712 53.32% Total Liabilities $14,464 100.00%

Weighted Averaged Cost of Debt 3.98%

Short Term Liabilities Principal (Millions) Rate Weight Value Weighted RateCurrent Maturity of Long Term Debt 160 6.79% 8.87% 0.60%Other Borrowings, 3.2% and 5.1% 1644 4.15% 91.13% 3.78%

1804 4.38%Amount Reclassified to Long Term Debt (750)

Total Principal 1054Long Term Debt Principal (Millions) Rate Weight Value Weighted RateShort Term Borrowings Reclassified 750 4.15% 29.33% 1.22%Notes Due: (2005-2026) 4.7% and 5.7% 1274 5.20% 49.82% 2.59%Zero Coupon Note, Yield 13.4% $575 Mill due (2005-2012) 321 13.40% 12.55% 1.68%Other, Due (2005-2014), 6.2% and 6.4% 212 6.30% 8.29% 0.52%

2557 6.01%Less Current Maturity of Long Term Debt Obligations (160)Total Long Term Debt 2397

68

Appendix

69

Exhibit 3

Weighted Average Cost of Capital

Value of Equity:PPS Shares Outstanding

$52.76 1,687,000,000$89,006,120,000.00

Value of DebtCurrent Maturity of Long Term Debt $2,397,000,000Long Term Debt $1,054,000,000

$3,451,000,000.00

Value of Firm $92,457,120,000.00

WACC= (Vd/Vf)*(1-Tx)*Kd+(Ve/Vf)*Ke 4.80%Tx= 31.66%

Appendix

70

EXHIBIT 4 Method of Comparables

2005 EPS BPS DPS PPS SPS PepsiCo 2.55 8.15 0.98 52.76 18.90Coca-Cola 2.05 6.40 1.08 41.38 9.40Cadbury Schweppes 2.20 15.20 0.93 40.00 23.95 P/E Ratio (PPS/EPS) PepsiCo 20.69 (Not Included in Average) Coca-Cola 20.19 Cadbury Schweppes 18.18

Avg 19.18 Price 48.92

P/B Ratio (PPS/BPS) PepsiCo 6.47 (Not Included in Average) Coca-Cola 6.47 Cadbury Schweppes 2.63

Avg 4.55 Price 37.07

Dividend Yield (DPS/PPS) PepsiCo 0.02 (Not Included in Average) Coca-Cola 0.03 Cadbury Schweppes 0.02

Avg 0.025 Price 39.72

P/S Ratio (PPS/SPS) PepsiCo 2.79 (Not Included in Average) Coca-Cola 4.40 Cadbury Schweppes 1.67


PEG Ratio PepsiCo 1.88 (Not Included in Average) Coca-Cola 2.17 Cadbury Schweppes 2.20


Appendix

The discounted free cash flow method. EXHIBIT 5 WACC = 0.048 Kd = 0.0398 Ke = 0.0488 Growth = 0.02

PepsiCo (Amounts in millions of dollars except per share data) Years from valuation date 1 2 3 4 5 6 7 8 9 Per 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Cash Flow from Operations 5,678 5,961 6,437 6,887 7,300 7,738 8,023 8,613 9,129 Cash Provided by Investing Activities (4,040) (4,242) (4,581) (4,810) (5,099) (5,303) (5,674) (6,071) (6,193) Free Cash Flow (to firm) 1,638 1,719 1,856 2,077 2,201 2,435 2,349 2,542 2,936 2,995 discount rate (4.8% WACC) 0.95 0.91 0.87 0.83 0.79 0.75 0.72 0.69 0.66 Present Value of Free Cash Flows 1562.98 1565.14 1612.48 1721.83 1741.06 1837.94 1691.82 1746.97 1925.33 Total PV of Annual Cash Flows 15,406 Continuing (Terminal) Value 106954 PV of Continuing (Terminal) Value 70,137

Value of the Firm (end of 2005) 85,542 Sensitivity Analysis Book Value of Debt $3,451 g Value of Equity (end of 2005) 82,091 0 0.01 0.02 0.04 Estimated Value per Share 12-31-05 48.66 WACC 0.02 $81.45 $154.56 N/A N/A Estimated Value per Share 04-01-05 47.90 0.03 $52.46 $74.78 $141.75 N/A 48.66/(1+(WACC/12)^(9/12) 0.048 $30.85 $37.13 $47.90 $150.21 Actual Price per share $52.76 0.06 $23.71 $27.15 $32.32 $58.18 WACC 0.048 Growth 0.02 0.048=(3451/85542)*0.0398+(82091/85542)new Ke New Ke = 0.0484

71

Appendix

Discounted Dividend Method EXHIBIT 6WACC = 0.048, Kd =0.0398, Ke(new) = 0.0484, Growth =0

PepsiCo (Amounts in millions of dollars except per share data)

Years from valuation date 1 2 3 4 5 6 7 8 9 Perp2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Dividends per share $1.12 $1.28 $1.39 $1.50 $1.72 $1.86 $1.97 $2.10 $2.23 $2.23Present Value Factor 0.954 0.909 0.868 0.828 0.789 0.753 0.718 0.685 0.653

Present Value of Future Dividends $1.07 $1.16 $1.21 $1.24 $1.36 $1.40 $1.41 $1.44 $1.46

Total PV of Forecast Future Dividends $11.75Continuing (Terminal Value) (growth of 0.02) $46.07

Present Value of Continuing (Terminal) Value $31.56

46.04*0.685 Sensitivity AnalysisEstimated Value per Share 12-31-05 $43.31 gEstimated Value per Share 04-01-05 43.18 0 0.01 0.02 0.05

54.44/(1+(Ke/12))^(9/12) Ke 0.02 $87.86 $164.01 N/A N/A0.0257 $70.79 $108.71 $278.90 N/A

Actual Price per share $52.76 0.0484 $43.18 $51.37 $65.53 N/ANew Cost of Equity 0.0484 0.056 $38.91 $44.82 $54.02 $265.54growth rate 0 0.07 $33.47 $37.09 $42.17 $87.86

72

Appendix

Discounted Residual Income EXHIBIT 7WACC= 0.048, Kd =0.0398, New Ke= 0.0484 Growth =0


Beginning BE (per share) 8.15 9.59 11.55 12.58 13.56 14.42 15.18 15.76 16.31Earnings Per Share $2.56 $2.60 $2.42 $2.53 $2.58 $2.62 $2.55 $2.65 $2.70Dividends per share $1.12 $1.28 $1.39 $1.55 $1.72 $1.86 $1.97 $2.10 $2.23Ending BE (per share) 8.15 9.59 10.91 12.58 13.56 14.42 15.18 15.76 16.31 16.78"Normal" Income 0.39 0.46 0.53 0.61 0.66 0.70 0.73 0.76 0.79Be *KeResidual Income (RI) 2.17 2.14 1.89 1.92 1.92 1.92 1.82 1.89 1.91 1.91EPS - NIPresent Value Factor 0.95 0.91 0.87 0.83 0.79 0.75 0.72 0.69 0.65Present Value of RI 2.07 2.04 1.80 1.83 1.83 1.83 1.73 1.80 1.82

BV Equity (per share) 2005 8.15Total PV of RI (end 2005) 16.76

Continuation (Terminal) Value 39.48 Sensitivity AnalysisPV of Terminal Value (end 2005) 27.0539.48*0.69 gEstimated Value per share 12-31-05 $51.96 0 0.01 0.02 0.05Estimated Value per share 04-01-05 $51.80 Ke 0.02 $129.53 $230.53 N/A N/A51.96/(1+(Ke/12)^(9/12) 0.0257 $100.00 $146.01 $353.42 N/A

0.0484 $51.80 $58.85 $70.79 N/AActual Price per share $52.76 0.056 $44.45 $48.92 $55.88 $215.86Ke 0.0484 0.07 $35.07 $37.23 $40.24 $67.37Growth 0

73

Appendix

Abnormal Earning Growth Model EXHIBIT 8WACC= 0.048, Kd =0.0398, New Ke= 0.0484 Growth =0

PepsiCo (Amounts in millions of dollars except per share data)


EPS 2.55 $2.56 $2.60 $2.42 $2.53 $2.58 $2.62 $2.55 $2.65 $2.70DPS 0.98 $1.12 $1.28 $1.39 $1.55 $1.72 $1.86 $1.97 $2.10 $2.23DPS invested at 4.84% 0.047 0.054 0.062 0.067 0.075 0.083 0.090 0.095 0.102Cum-Dividend Earnings 2.607 2.654 2.482 2.597 2.655 2.703 2.640 2.745 2.802Normal Earnings 2.673 2.684 2.726 2.537 2.652 2.705 2.747 2.673 2.778Abnormal Earning Growth (AEG) (0.066) (0.030) (0.244) 0.060 0.003 (0.002) (0.107) 0.072 0.023 0.023PV Factor 0.954 0.910 0.868 0.828 0.790 0.753 0.718 0.685 0.654

PV of AEG (0.063) (0.027) (0.212) 0.050 0.002 (0.001) (0.077) 0.049 0.015Core EPS 2.560Total PV of AEG -0.263Continuing (Terminal) Value $0.48PV of Terminal Value 0.331Total PV of AEG

Average Perpetuity 2.628 Sensitivity AnalysisCapitalization Rate (perpetuity) 0.048 gEstimated Value per Share 12-31-05 54.294 0 0.01 0.02 0.05Estimated Value per share 04-01-05 54.130 Ke 0.02 $86.18 $120.47 N/A N/A54.29/(1+Ke/12)^9/12 0.0257 $74.36 $89.31 $156.69 N/AActual price per share 52.76 0.0484 $54.13 $55.90 $58.93 N/AKe 0.0484 0.056 $50.81 $51.80 $53.35 $88.87

g 0 0.07 $46.41 $46.74 $47.12 $51.34

74

Appendix

Exhibit 9

Long Run Average Residual Income Perpetuity based on the P/B Ratio


.


g

0 0.01 0.02 0.05

Ke 0.02 $127.30 $246.46 N/A N/A

BE 8.15 0.0257 $99.07 $156.98 $418.08 N/A

ROE 0.3124 0.0484 $52.60 $64.18 $83.91 N/A

0.056 $45.47 $53.58 $66.20 $356.43

0.07 $36.37 $41.08 $47.66 $106.93

75

Appendix

Sources

1. www.finance.yahoo.com

2. www.pepsico.com

3. www.moneycentralmns.com

4. http://edgarscan.pwcglobal.com

5. www.morningstar.com

6. www.stlouisfed.org

7. http://tabseacct.swlearning.com

8. Epic Software

9. Value Line

10. www.forbes.com

11. www.new-nutrition.com

76



http://www.moneycentralmns.com/

http://edgarscan.pwcglobal.com/

http://www.morningstar.com/

http://www.stlouisfed.org/

http://tabseacct.swlearning.com/

http://www.forbes.com/


business & industry analysis - texas tech...

Documents