A Twenty-Year Toothache
Thursday, May 31, 2018
The year was 1998. Google formally incorporated; Michael Jordan led the Chicago Bulls to yet another championship; Titanic broke through $1 billion in box office sales; and this author, living in Newfoundland, visited British Columbia for the first time. In the spring of that year, shares of The Coca-Cola Company traded above $401 which had never happened before. By the middle of July, the stock reached a high of $43.97. Today – twenty years later – Coca-Cola trades a little over $42 per share.
So, what happened? The business didn’t stop growing. In 1998, The Coca-Cola Company sold more than one billion eight-ounce servings of product every day. That number has almost doubled since. More impressive, the $2.10 in earnings per share Coca-Cola expects to earn this year is almost three times the $0.70 it earned in 1998. So why has the stock price stagnated? The main problem is valuation; that is to say that investors were paying too much for the stock in 1998. A company’s valuation should not be confused for its share price. A $10 stock may be more richly valued than a $100 stock.
To better understand this, analysts commonly use a price-to-earnings (P/E) multiple, which is calculated by dividing the current share price by earnings per share. This metric provides limited insight on its own, as it varies by company and industry based on factors such as profitability, growth and financial strength. Nevertheless, simplistically speaking, the higher the P/E ratio, the more “expensive” the stock.
In 1998, investors were giddy with excitement as they paid ever higher prices for large American companies. In the case of Coca-Cola, the stock peaked at a P/E ratio of almost 63 that year. Today, the stock trades at 20 times earnings per share. An astute shareholder in 1998 would have been absolutely right to predict solid growth of the company, but they would have collected only a modest dividend and received no growth in the share price. Sentiment around the stock began to change as investors didn’t want to pay such a high valuation and the share price declined causing the P/E multiple to compress. Almost all the benefit an investor would have enjoyed from the company’s earnings growth was offset by this decline in the valuation.
Evaluating future profitability is extremely important in investing, but a bright future for a business does not necessarily mean a good investment. Valuation matters. Interestingly, we recommended Coca-Cola as an investment in 2005 when the stock was trading at 20 times earnings per share. In 2014, when we decided to sell, the stock was still trading at a 20 times multiple, but it had generated a total return of 144%. We were able to benefit from the growth of the business without losing to a declining valuation multiple.
Today, we believe the valuation multiples of the high-quality businesses we recommend are reasonable. As such, we believe these stocks should deliver a decent return for investors over time. However, we continually monitor these companies to ensure that the future prospects for both the business and the stock price remain bright. While a lot has changed over the last twenty years, the principles of sound investing, such as paying a reasonable price, have not.
1Price adjusted for a 2012 stock split