An Important Discussion on the Nuances of Valuation

2015-06-23

Can I Have a Hamburger and a Coke?  Sorry, is Pepsi Okay?

When I was studying business marketing in college, I was introduced to the concept referred to as the first mover advantage.  In very simple terms, this refers to the advantages of being the first to develop a product and market.  For example, instead of asking for a tissue, a person might ask for a Kleenex because Kleenex was the first mover.  Typically, the person really doesn’t care if you offer them a Kleenex or a Puff tissue; they simply want to blow their nose.  However, because Kleenex essentially was the first mover, it became what could be called a “genericized” replacement term for a facial tissue.

The same could be said for Coke (KO).  Many times in my life I have ordered a hamburger and a Coke for lunch without really caring which cola drink I was served.  However, if the restaurant carried both Coke and Pepsi (PEP) products, I would automatically be served a Coke.  On the other hand, if only Pepsi was available, I would typically be politely asked if Pepsi was okay?  This is obviously a first mover advantage for Coke.  However, it is also true that both Coke and Pepsi have over the years become ubiquitous and even interchangeable terms for cola.

From a dividend growth stock investor’s point of view, a similar concept regarding the investment merit of both companies, Coke and Pepsi, also applies.  Both of these companies do business in essentially the same sector – Consumer Goods.  But more importantly, both companies have historically commanded similar fundamental metrics and valuation levels.

For example, both companies have grown earnings and dividends at similar rates, and both companies have typically been awarded a quality premium valuation.  Consequently, if a prudent dividend growth investor wanted to own either of these blue-chip Dividend Champions or Aristocrats, they would typically be required to pay a higher valuation based on earnings than they might for other high-quality blue-chip dividend growth stocks.  In other words, the typical valuation based on earnings hasn’t historically applied to these blue-chip dividend growth stocks.

Since that is true, and history indicates that it is, this creates a conundrum of sorts for the value-oriented dividend growth investor.  Should they be willing to pay the premium valuation that the market typically asks to invest in these high profile consumer goods companies, or do they need to think about valuation differently when considering investments in either Coke or Pepsi?  Although I leave the answer to those important questions up to each individual investor and their own goals, objectives and risk tolerances, there are what I would call “nuances of valuation” that they might also want to consider.  These nuances of valuation calculations seem to apply to many of the highest quality blue-chip dividend growth stocks, especially those that are found in what is often considered as defensive industries.

Now here I will add that I hold my own personal view of why these nuances of valuation apply differently to these companies than valuation calculations typically applies to others. But simultaneously I must admit that it is only a theory.  On the other hand, there is evidence that suggests that my theory is at least logical, backed up by real-world history and therefore perhaps valid.  Therefore, I will offer my theory coupled with the supporting real-world evidence and let each of you decide for yourselves.

Very importantly, my theory also facilitates the importance of utilizing all of the analytical power that the F.A.S.T. Graphs™ fundamentals analyzer software tool provides.  Calculating fair value can never be done with perfect precision.  In other words, there is no such thing as an absolute or perfect fair value calculation.  Nevertheless, fair valuation can be calculated within a reasonable enough degree of accuracy to be of important value to investors.  Additionally, reasonable calculations of fair valuation empower the investor to make realistic calculations of the potential future returns that an investment in a fairly valued common stock might offer.

The analyze-out-loud video attached to this article utilizes blue-chip dividend paying stalwarts Coke and Pepsi to illustrate both the nuances of valuation, as well as the additional analytical power of F.A.S.T. Graphs™.  I hope you find the presentation interesting and useful, but most importantly, I hope it provides additional insights into the importance of valuation and how it might be ascertained differently for different types of companies.

Disclosure:  Long KO and PEP at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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