Financial Analysis of PepsiCo.

FNC 474-01

Intermediate Financial Management

Tyree Etheridge

October 20, 2015

1

Table of Contents

Introduction & History of PepsiCo.

Chapter 1: Financial Ratio Analysis of PepsiCo.

Chapter 2: The Extended DuPont System of Financial

Analysis

Chapter 3: The Long-term Growth Rate

Chapter 4: The Beta Coefficient & Required Rate of

Return on Equity of PepsiCo.

Chapter 5: Free Cash Flow to Equity of PepsiCo.

Chapter 6: Valuing PepsiCo.

2

Introduction

PepsiCo, as it’s named today, was not always the company it is now. The soft drink giant

began its life as the 1893 creation of Caleb Davis Bradham, a North Carolina pharmacist who

created the drink to aid in digestion. The original mixture created by Bradham was made using

water, caramel, sugar, lemon oil, nutmeg, and other ingredients and was named Brad’s drink

after its creator. Brad’s drink was an immediate success among Bradham’s drugstore clients as it

was thought of as a healthy daily beverage. In August 1898, Caleb Bradham renamed his

beverage from Brad’s drink to Pepsi-Cola after purchasing the Pep Cola name from a competitor

for $100 and in 1902 formed the Pepsi-Cola company. The rising demand for the original Pepsi

syrup caused Bradham to trademark the mixture and name on June 16, 1903. Within its first

year of business, Pepsi-Cola sold 7,968 gallons and by 1904 Pepsi-Cola was selling

approximately 20,000 gallons of the syrup annually. The original Pepsi logo was designed by

Bradham’s artist of a neighbor in 1903. By 1904 Caleb Bradham had purchased a building in

New Bern, North Carolina to house Pepsi’s bottling operations and by 1906 there were 15

bottling plants resulting in syrup sales of 38,605 gallons. Pepsi was originally sold in 6 ounce

glass bottles with the Pepsi logo on the front until 1934 when Pepsi began offering 12 ounce

bottles for 5 cents.

Throughout the years from the early 1900’s to WWI, Pepsi grew exponentially and saw

great success; however, the firm suffered hard times during the years of WWI as the price of

sugar rose since it was being rationed by the U.S. government. The rationing and price of sugar

kept Pepsi from being able to meet its consumers’ supply demands. Despite Caleb Bradham’s

attempts at producing a sugar substitute, Pepsi fell short of major demand needs and ultimately

forced Caleb Bradham and Pepsi to file bankruptcy on May 31, 1923, with its assets being sold

3

for $30,000 to Craven Holding Corporation. In the same year Craven Holdings sold Pepsi to a

Wall Street broker named Roy C. Megargel, who purchased the firm for $35,000 forming the

Pepsi-Cola Corporation. After several years of continuous profit loss, Megargel was forced to

file bankruptcy; the second bankruptcy for Pepsi Cola. The firm was purchased in 1931 by

Charles G. Guth, president of the Loft Candy Company. In 1934 it was Guth who decided to

double the size of the Pepsi bottle to 12 ounces and sell it for 5 cents a bottle. In 1940 Pepsi

made history being the first company to have a nationally broadcast jingle with its “Nickel

Nickel” advertisement for the 5 cent 12 ounce bottle.

Pepsi continued to flourish for the next 30 years making major acquisitions along the way

such as its 1964 introduction of diet Pepsi as well as the acquisition of Mountain Dew from the

Tip Corporation. The following year Pepsi-Cola merged with Frito-Lay, a snack foods company

created in 1938 by Herman Lay. This merger created the Pepsi Corporation also known as Pepsi-

Co. After this successful merger, Pepsi-Co began a series of acquisitions of brands outside of its

soft drink industry such as Pizza Hut, Taco Bell, California Pizza Kitchen, and Wilson Sporting

Goods to name a few. PepsiCo held on to these acquisitions until 1997 when it sold some and

spun the others off into a new firm named Tricon Global Restaurants which was later renamed as

Yum Brands. In 2006 PepsiCo named Indra K Nooyi as its Chief Executive Officer, the first

female CEO in Pepsi’s 100 year history. Prior to becoming the CEO, Nooyi was the firm’s Chief

Financial Officer for five years. Prior to that she was Senior Vice President of Strategic Planning

for four years. As Chief Executive Officer, Indra Nooyi has directed Pepsi’s global strategy for

more than 8 years.

4

Chapter 1: Financial Ratio Analysis

Financial Statements

The financial statements for PepsiCo were retrieved from EDGAR SEC and included the

consolidated statement of income, consolidated balance sheets, and the consolidated statement of

cash flows. The ticker symbol for PepsiCo was retrieved from Yahoo Finance: EDGAR refers to

the Electronic Data Gathering Analysis and Retrieval system, operated by the Securities and

Exchange Commission. The statements of PepsiCo. Were pulled from the ten previous years of

10-K documents. The data retrieved from the consolidated statement of income includes sales,

cost of goods sold, operating expenses, EBIT, interest expense, and net income, while the

consolidated balance sheet gives us accounts receivable, inventory, current assets, depreciation,

net fixed assets, accounts payable, current liabilities, long-term debt, retained earnings, total

owners’ equity, total liabilities, and owners’ equity and shares outstanding. The data retrieved

from the consolidated statement of cash flows includes dividends, historical stock prices, and

historical shares outstanding for the last 11 years.

5

Financial Ratio Analysis

Financial ratio analysis is the quantitative analysis of information contained in a

company’s financial statements. It’s commonly utilized by investors to value firms for purchase.

Financial ratio analysis serves as an evaluation tool used to analyze a firm’s financial standing.

These ratios are commonly used to compare different firms within the same industry. Financial

ratios fall under five categories: liquidity ratios, asset management ratios, financial leverage

ratios, profitability ratios, and market based ratios.

6

7

Liquidity Ratios

Liquidity ratios measure the firm’s ability to pay off short term debts and obligations.

These ratios are metrics used to ensure that the firm has the required amount of cash and short

term assets that include accounts receivables and inventories, which are used to meet short term

debts such as accounts payable. It is generally understood that the higher the liquidity ratio, the

greater the ability that the firm has to meet short term obligations. There are two liquidity ratios,

which are the current ratio and the quick ratio. The current ratio is also known as the working

capital ratio and is the going concern that indicates the amount of short-term assets that firm has

with relation to each dollar of short-term liabilities and is calculated by dividing the firm’s

current assets by its current liabilities. The quick ratio is the ratio that is used to measure a firm’s

short term liquidity, or its abilities to meet short term obligations when inventory is not being

properly converted into cash. Ultimately the quick ratio measures the dollar amount of liquid

assets available for each dollar of current liabilities and is calculated by subtracting inventories

from current assets and dividing that number by current liabilities.

8

Asset Management Ratios

Assets are the most valuable aspects of any firm, and therefore, should be maintained and

ensured against error. Asset management ratios measures how efficiently the firm utilizes these

assets to generate business. There are four asset management ratios: day’s sales outstanding,

inventory turnover, net fixed assets, and total asset turnover. The day’s sales outstanding ratio

measures the average number of days it takes a company to collect revenue (accounts receivable)

once a sale has been made. While a small day’s sales outstanding value means that it’s taking a

firm a short amount of time to collect its revenue, a large day’s sales outstanding value means

that it’s taking a firm a long amount of time to collect its accounts receivable. The day’s sales

outstanding ratio can be calculated by dividing annual sales by 365, then dividing that number

into receivables. The inventory turnover ratio shows the amount of times that that the inventory

of a firm is sold and replaced over a fixed period. In addition the inventory turnover ratio also

depicts how many dollars of sales the company generates for each dollar of inventory and is

9

calculated by dividing sales by inventory. Net fixed assets turnover measures the number of

dollars of sales generated for each dollar of inventory and is calculated by dividing sales over

fixed assets. The highest level for net fixed asset turnover was .33 in 2006 and the lowest

being .26 in 2014. Total dollar of total assets. It is calculated by dividing sales over total assets

asset turnover ratio refers to the number of dollars of sales generated for each sale. The highest

total asset turnover ratio was 1.20 in 2008 while the lowest value was .75 in 2011.

10

Financial Leverage Ratios

Financial leverage ratios indicate how much debt and owner’s equity the firm uses to

finance its operations, or simply the extent to which Pepsi used debt to finance its assets. Using

debt to finance assets increases Pepsi’s return on equity. There are four financial leverage ratios:

total debt ratio, debt-to-equity ratio, equity multiplier, and times earned interest. The total debt

ratio defines the total amount of debt relative to the total amount of assets. It’s a measure of the

funds provided by creditors and includes both current and future liabilities. The total debt ratio is

calculated by dividing total debt over total assets with the highest value occurring in 2014 with a

value of .75 and the lowest occurring in 2006 with a value of .49. The debt-to-equity ratio

11

measures a firm’s financial leverage by calculating the total debt to total equity. A low debt to

equity ratio indicates low financial leverage and relatively low risk, while a higher debt to equity

value indicates higher financial leverage and more risk. The debt to equity ratio is calculated by

dividing total debt over total owner’s equity. The highest debt to equity value occurred in 2014

with a value of 3.80 and the lowest occurring in 2004 with a value of 2.16. The equity multiplier

is a measurement of the firm’s financial leverage and is the ratio of the firm’s assets to its

owner’s equity. The equity multiplier is calculated by dividing total debt over owner’s equity.

The highest equity multiplier occurred in 2014 with a value of 4.02 and the lowest occurring in

2004 with a value of 2.06. Times interest earned is the ratio of earnings before interest and taxes

and indicates how much earnings before interest and taxes can decrease before earnings before

interest and taxed is less than the interest expense. The highest times interest earned value

occurred in 2007 with a value of 34.12, while the lowest occurred in 2010 with a value of 2010.

12

Profitability Ratios

Profitability ratios are the indicators of a firm’s profitability and measure the firm’s

overall ability to generate earnings as compared to its sales and expenses. Profitability ratios are

operating margin, basic earning power, net profit margin, return on assets, and return on equity.

Operating margin is the measurement of operating income and sales. In addition operating

margin measures the amount of revenue that is left over once operating costs have been paid.

The operating margin is calculated by earnings before interest and taxes (EBIT) over sales. The

highest operating margin occurred in 2005 and 2006 with a value of .20, while the lowest value

occurred in 2011 and 2012 with a value of .13. In addition I noticed that 2004, 2007 and 2009

13

contained the same value of .19. Net profit margin refers to the ratio of net income to sales and

depicts how well revenue is turned into profits. In addition net profit margin measures the overall

operating efficiency of the firm and can be calculated by dividing net income over sales. Net

profit margin remained at a constant of .14 for 2004, 2007, and 2009. Return on assets indicates

the profitability of a firm compared to its total assets and measures how efficiently the firm uses

its assets to generate profit. The return on assets ratio can be calculated by dividing net income

over total assets. The highest return on assets value occurred in 2006 with a value of .19, while

the lowest value occurred in 2012 with a value of .08. The value of.09 occurred in 2010, 2011,

2013, and 2014. The final profitability ratio is return on equity which is the ratio of net income to

the equity of shareholders and measures the amount of profit that a firm generates for each dollar

of shareholder’s equity. Return on equity is calculated by dividing net income over owner’s

equity. The largest return on equity value occurred in 2008 with a value of .41, while the smallest

value occurred in 2005, with a value of .28; the same value also occurred in 2012 and 2013.

14

Market-Based Ratios

Market-based ratios show the value of the firm based on the opinions of shareholders.

This value is equal to the firm’s market capitalization, which is calculated by multiplying the

firm’s outstanding shares by the price of each share. There are eight market-based ratios that

include earnings per share, price to earnings ratio, book value ratio, market value ratio, payout

ratio, earnings retention ratio, dividends per share ratio, and dividend yield. The earnings per

share ratio measures the amount of income earned for each share of common stock issued to

shareholders and is calculated by dividing net income over the number of shares outstanding.

The largest earnings per share value occurred in 2013 with a value of 4.44, whole the smallest

15

value occurred in 2005 with a value of 2.29. The price-to-earnings ratio is a method used to

value firms and measures the amount that shareholders will pay for each company the firm earns.

The price to earnings ratio is calculated by dividing the market price per share over the earnings

per share. The highest value for this ratio occurred in 2005 with a value of 25.82, while the

lowest value occurred in 2011 with a value of 16.07. The book value ratio indicated the stock

price based on the value of the firm. It’s a measure to indicate the dollar value for shareholders

after all assets are liquidated and debtors paid, should the firm ever go belly up. The book value

per share can be calculated by dividing total owner’s equity over the number of shared

outstanding. The highest book value per share occurred in 2013 with a value of 15.95, while the

lowest value of 7.06, occurred in 2008. The market value ratio, used to value the current share

price of a firm, shows the number of dollars shareholder’s pay for each corresponding dollar of

book value. The market value ratio is calculated by dividing the current stock price per share by

the current book value per share. The largest market value was 8.02 and occurred in 2014, while

the smallest market value, which occurred in 2012, was 4.72. The payout ratio is the percentage

of net income paid out as dividends to shareholders and is used to determine the sustainability of

a firm’s dividend payments. The payout ratio is calculated by dividing dividends per share over

earnings per share. The largest payout ratio value occurred in 2013 with a value of 4.44, and the

smallest value of 2.29 was observed in 2005. The earnings retention ratio measures the

percentage of earnings that the firm keeps as retained earnings and is also the percentage of net

income used to grow the firm. The retention ratio is the opposite of the payout ratio because the

earnings are kept within the firm as opposed to being paid out as dividends to shareholders. The

earnings retention ratio can be calculated by dividing dividends over net income. The largest

earnings retention value of .57 was observed in 2014, while the smallest value of .32 occurred in

16

2004. The dividends per share ratio measures the total dividends paid out to shareholders and is

calculated by dividing the number of dividends over the number of shares. The highest dividends

per share value occurred in 2014 with a value of 2.51, while the lowest value occurred in 2004

with a value of .75. The final market based ratio is the dividend yield, which is a measure of how

much the firm pays out in dividends annually relative to the price per share. Dividend yield is

typically calculated as a percentage by dividing dividends per share over stock prices.

17

18

Summary and Conclusion:

Financial ratio analysis serves as an evaluation tool. There are five categories of financial

ratios which are used. They are liquidity ratios, asset management ratios, financial leverage

ratios, profitability ratios, and market-based ratios. Liquidity ratios include the current ratio and

the quick ratio which are used to determine a firm’s ability to quickly convert its assets into cash

to meet its short-term obligations. Since assets are resources used in a business to produce a

profit or return, asset management ratios are used to determine how effectively a company

utilizes these assets to such. Financial leverage ratios are used to determine the amount of debt

used to finance a company’s assets and allows one to determine how well the company can meet

its long-term debt obligations. Profitability ratios analyze the company’s profitability based on

19

its relationship between sales and expenses. Market based ratios provide an idea of what the

company’s investors think of its performance and future prospects.

References

1. "The History of Pepsi-Cola." The History of Pepsi-Cola. Leader Distribution Systems,

Inc., 2012. Web. 20 Oct. 2015.

2. "Journey: A Glimpse Into The History of Pepsi Bottles." Bottle Bonanza. Bottle Bonanza,

28 Nov. 2010. Web. 20 Oct. 2015.

3. "Pepsi Store - History of the Birthplace of Pepsi." Pepsi Store - History of the Birthplace

of Pepsi. Pepsi Store, n.d. Web. 20 Oct. 2015.

Chapter 2: DuPont System of Financial Analysis

The DuPont system of financial analysis utilizes a financial model that is based upon the

return on equity (ROE) of the business. The DuPont system of financial analysis was created by

the DuPont coporation in the mid 1920’s as a way to measure asets at their gross book value as

opposed to their net book value in order to produce a higher return on equity. DuPont analysis

relies on return on equity (ROE) as a way to estimate the value of a firm using its equity. Return

on equity relies on three variables, which include net profit margin (NPM), total asset turnover

(TAT), and the equity multiplier (EM). Net profit margin refers to the ratio of net income to sales

and depicts how well revenue is turned into profits. In addition net profit margin measures the

overall operating efficiency of the firm and can be calculated by dividing net income over sales.

20

Since net profit margin measures a firm’s profitability, firms with larger net profit margins are

more profitable and efficient than those with lesser values. Total asset turnover measures the

firm’s efficiency in using its assets to generate sales and can be calculated by dividing sales over

total assets. Firms with larger total asset turnover ratio values are more efficient at generating

more sales per dollar of assets than firms with smaller values. The equity multiplier serves as a

measure of the financial leverage of the firm and is the ratio of the firm’s assets to its owner’s

equity. The equity multiplier is calculated by dividing total debt over owner’s equity; therefore, a

higher equity multiplier ratio shows that the firm is relying heavily on debt to finance its assets.

Return on equity can be broken down into return on assets (ROA) and the equity multiplier.

Return on assets can be further broken down into net profit margin and total asset turnover.

ROE= (ROA)*(EM)

ROA= (NPM)*(TAT)

ROE= (NPM)*(TAT)*(EM)

Where,

ROE= Return on equity

ROA= Return on Assets

EM= Equity multiplier

NPM= Net Profit Margin

TAT= Total Asset Turnover

NPM= (NI)/(S)

21

TAT= (S)/ (TA)

EM= (TA)/ (OE)

Where,

NPM= Net Profit Margin

NI= Net Income

S= Sales

TAT= Total Asset Turnover

TA= Total Assets

EM= Equity Multiplier

OE= Owner’s equity

The DuPont system of financial analysis is one that is based on the return on equity

model that breaks down return on equity into three components which include net profit margin,

total asset turnover, and the equity multiplier. Net profit margin ratio gives the analyst the ability

to predict the income statement and components of it to include revenues and expenses. To

achieve the ideal return on equity to shareholders, a firm must first determine the amount of net

income required. Total revenue is then forecasted from the required net income which is based

on the net profit margin ratio. Total asset turnover gives the analyst the ability to forecast the

left-hand side of the balance sheet which corresponds to assets. The total revenue projection is

utilized to predict the required amount of total assets. Based on this information, managers can

22

determine the ratio of current assets to total assets and the composition of assets. Since total

assets must equal to liabilities plus owner’s equity, the equity multiplier gives the analyst the

ability to forecast the right-hand side of the balance sheet. Therefore, the company must issue

debt to keep its ratio constant. Based on the DuPont system of financial analysis, the company is

now able to develop pro forma financial statements, more specifically the income statement and

the balance sheet.

The DuPont system of financial analysis serves three functions within the company.

First, it allows the company to forecast future operations through pro forma financial statements

which may be depicted as a budget or financial plan. Second, it can be used a control mechanism

that can monitor the company’s performance throughout the year. This will allow the firm to take

the necessary corrective actions required if the company’s operating performance deviates from

the budget. Third, it can be used as a post-performance audit function. At the end of the year, the

firm can compare actual operating performance with planned operating performance to detect

any deviations from the plan. In the long run, effective performance budgeting should result in

the deviation from the budget being near zero. If not, the company may be under or over

budgeting.

Return on equity analysis provides a system for planning and for analyzing a company’s

performance. The net profit margin allows the analyst to develop a pro forma income statement,

as in figure 3-1. The top box of figure 3-1 shows an abbreviated income statement where net

income is equal to revenues minus expenses. Given a target ROE, the financial manager can

determine the net income needed to achieve the target ROE. From the target ROE, the financial

manager can determine the revenue level necessary to achieve the net income target. The middle

box of figure 3-1 shows how the financial manager can use the total asset turnover ratio to

23

project the total asset level necessary to generate the projected revenue level. Given a level of

projected revenue, the financial manager can project the level of total assets needed to produce

the projected level of revenues. The total asset requirement can be used to project the pro forma

levels of all of the asset accounts. The fundamental equation of accounting is that assets equal

liabilities plus owners’ equity. The bottom box of figure 3-1 shows how the financial manager

uses the equity multiplier ratio can be used to project the pro forma financial needs and the

financial structure of the company. Total liabilities and equity must be equal to the projected

total asset requirements.

Figure 3-1

Using the DuPont System of Financial Analysis to develop Pro Forma Financial Statements

NPM=(NI)(S)

Sales – Total Costs = Net Income

TAT= (S) (TA)

Current Assets + Fixed Assets = Total Assets

EM = (TA) (OE)

Total Liabilities + Total Equity = Total Liabilities + Owner’s Equity

The DuPont system of financial analysis has three uses. First, it can be used for forecast

purposes to construct pro forma financial statements for PepsiCo. Second, it can be used by

24

PepsiCo to monitor performance during the planning process. Third, it can be used to audit the

planning process.

Computing Sustainable Growth

This model is called the DuPont system of financial analysis and the extended DuPont

System is used to compute sustainable growth. Sustainable growth, G, is equal to ROE times the

retention rate which is one minus the payout ratio.

G = ROE (RR)

= (NI/OE)/ (1-D/NI)

Where,

G = sustainable growth

ROE = return on equity

RR = dividend retention rate

NI= Net Income

OE = Owners Equity

D = Dividends

Sustainable growth refers to the attainable growth that the firm can maintain without

running into problems. A business that grows too quickly may find it difficult to fund the growth,

while a business that grows too slowly or not at all, may become stagnate. Since the asset to

beginning of period equity ratio is constant and the firm's only source of new equity is retained

25

earnings, sales and assets cannot grow any faster than the retained earnings plus the additional

debt that the retained earnings can support.

Assets = Liabilities + Equity

As a result of this assumption requiring that assets equal liabilities plus owners’ equity, any

changes in assets must be equal to changes in liabilities plus changes in owners’ equity.

Δ Assets = Δ Liabilities + Δ Equity

Furthermore, the sustainable growth model assumes that any change in equity can only result

from a change in retained earnings. Therefore, the firm cannot sell additional owners’ equity.

Δ Assets = Δ Liabilities + Δ Retained Earnings

This means the company’s future increase in assets is equal to the future increase in retained

earnings plus the additional debt that is supported by the additional owners’ equity as determined

by the equity multiplier. The equity multiplier is equal to total assets divided by owners’ equity.

Δ Assets = (Δ Retained Earnings) (Equity Multiplier)

[3-10]

An increase in total revenue must be accompanied by a proportionate increase in total assets.

Since any increase in total revenue is limited by the increase in total assets, growth in total

revenue is limited by the increase in retained earnings. Total asset turnover is equal to sales

divided by total assets.

26

Δ Total Revenue = (Δ Total Assets) (Total Asset Turnover)

[3-11]

The net income required to achieve the target return on equity is determined by total revenue

times the net profit margin. Net profit margin is equal to net income divided by total revenue.

Δ Net Income = (Δ Total Revenue) (Net Profit Margin)

Earnings retention is equal to retained earnings divided by net income.

Earnings Retention = Retained Earnings/Net Income

Sustainable growth is equal to return on equity times the earnings retention rate of the company.

Sustainable Growth = (Return on Equity) (Earnings Retention)

Analysis of ROE and Sustainable Growth for PepsiCo.

The following table contains the data and ratios for the DuPont system of financial

analysis of return on equity as well as the analysis of sustainable growth (G) for PepsiCo based

on data from 2005 to 2014. Lines two through 6 contain the raw data that was used to compute

the ratios used in the DuPont system of financial analysis as well as in the computation of the

sustainable growth rate. From 2004 to 2014, total revenue for PepsiCo increased from $29,261

million to $66,683 million. Total revenue for PepsiCo. Increased every year over the sample time

period except for 2009 due to the nationwide recession. Net income rose from $4,212 million to

$6,558 million over the course of ten years. Total assets rose from $27,987 million to $70,509

27

million, but did not increase every year, they declined in 2006. Total owner’s equity rose every

year except 2008 and 2014, while dividends rose from $1329 million to $3730 million over the

sample time frame.

Lines seven through ten contain net profit margin, total asset turnover, equity multiplier,

and the earnings retention ratio, which are all the ratios needed to compute return on equity and

sustainable growth. Return on equity is computed two ways, first way being to dividing net

income by total owner’s equity. The second method to compute return on equity is done by

multiplying net profit margin by total asset turnover and if the two calculations yield the same

values, then the analysis correct and valid. Sustainable growth is calculated by multiplying

sustainable growth by the dividend retention ratio.

28

KO 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 AVERAGESales 29261 32562 35137 39474 43251 43232 57838 66504 65492 66415 66683 49622.64Net Income 4212 4078 5642 5658 5142 5946 6338 6462 6214 6787 6558 5730.64Total Assets 27987 31727 29930 34628 35994 39848 68153 72882 74638 77478 70509 51252.18Total Owners' Equity 13572 14320 15447 17325 12582 17442 21476 20899 22399 24389 17548 17945.36Dividends (-) 1329 1642 1854 2204 2541 2732 2978 3157 3305 3434 3730 2627.82Net Profit Margin 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00Total Asset Turnover 0.25 0.23 0.21 0.18 0.17 0.16 0.11 0.10 0.11 0.11 0.12 0.16Equity Multiplier 0.44 0.41 0.39 0.39 0.38 0.37 0.51 0.49 0.44 0.40 0.35 0.42Retention Ratio 0.68 0.60 0.67 0.61 0.51 0.54 0.53 0.51 0.47 0.49 0.43 0.55Return on Equity 0.3103 0.28 0.37 0.33 0.41 0.34 0.30 0.31 0.28 0.28 0.37 0.32Sustainable Growth 0.2124 0.1701 0.2452 0.1994 0.2067 0.1843 0.1564 0.1581 0.1299 0.1375 0.1612 0.18

20042005

20062007

20082009

20102011

20122013

2014

AVERAGE0

20000

40000

60000

80000

Figure 20DuPont Analysis

PepsiCo. 2005-2014

Sales Total Assets Total Owners' Equity

29

30

References

1. McGowan, Carl B., Jr., John C. Gardner, and Susan E. Moeller. The Fundamentals of Financial

Statement Analysis as Applied to the Coca-Cola Company. New York City: Business Expert, 2015.

Print.

31

Chapter 3: Determining the Long-Term Growth Rate

When valuing a company, both the long-term growth rate and immediate growth rate are

required. Long-term growth rates provide a reflection of the economy as a whole; however, the

possibility of a company growing at an even higher rate than the economy does not last for a

very long time. Eventually, large companies begin to grow at the rate of GDP.

When estimating long term growth for the firm, an estimate of long-term growth for the

entire economy is essential. To do so, the “current dollar” and “real gross domestic product”,

which are published by the U.S. Bureau of Economic Analysis, are needed. Since we are

estimating nominal values, “GDP in billions of current dollars” is used. To estimate long-term

growth rate for PepsiCo, we use the eleven years of GDP. The annual change in GDP, ΔGDP1, is

the difference in GDP from the current year, GDP1, and GDP from the previous year, GDP0,

divided by GDP from the previous year.

The table shows the values for GDP of each year during the period of 2014 to 2004,

along with the changes in GDP for each year. The average change for the entire period was

3.545%. This value is then used in the estimation of long-term growth for PepsiCo.

ΔGDP1= {GDP1- GDP0)/GDP0}

32

33

2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004-0.04

-0.02

0.00

0.02

0.04

0.06

0.08

Figure 21Change in GDP

Pepsico 2005-2014

34

Chapter 4: Calculating the Beta Coefficient and the Required Rate of Return

for PepsiCo.

Chapter 4 demonstrates how the rate of return is computed for PepsiCo using the modern

portfolio theory with the necessary data downloaded from the internet. It will demonstrate how

to calculate the monthly returns for PepsiCo and the S&P 500 stock Index, then show how to use

the returns to compute the beta co-efficient and the required rate of return. Also shown is how to

validate the data for the market index and company and how to calculate the returns using the

dividends and stock split adjusted prices. Included in this chapter is a demonstration of how to

graph the characteristic line and use the graph to ensure that the regression was run correctly.

Any company can be used, however, in this paper we will evaluate PepsiCo and S&P 500 Index.

This paper can be used as a reference in analyzing PepsiCo for investment purposes.

In 1952 Harry Markowitz created the modern portfolio theory (MPT) which can be used

to explain the relationship between risk and return for assets with specific emphasis on stocks.

In general, when the stock of a company has a high rate of return, the risk associated with it is

usually high and vice versa. Also called "portfolio theory" or "portfolio management theory,"

MPT suggests that it is possible to construct an "efficient frontier" of optimal portfolios, offering

the maximum possible expected return for a given level of risk. It suggests that it is not enough

to look at the expected risk and return of one particular stock. By investing in more than one

stock, an investor can reap the benefits of diversification, particularly a reduction in the amount

of risk of the portfolio. MPT quantifies the benefits of diversification, also known as not putting

all of your eggs in one basket. Non-systematic risk is risk that is particular to a company and

doesn’t affect other companies. Investors can protect against non-systemic risk by diversifying

35

their investments. Non-systemic risk contrasts with systemic risk, which is risk that applies to all

companies in a market or industry. The beta coefficient shows the movement of the returns for

the stock with the market. A higher beta coefficient shows that the return for the stock moves

more than the market (aggressive stocks) and a lower beta coefficient shows that the return

moves less (defensive stocks).

This paper will show how to retrieve the data from the internet for PepsiCo, as well as

how to compute returns for both the market index and the stock, and how to run a regression

analysis to determine the beta coefficient in an attempt to measure the systematic risk of the

stock. A graph displaying the trend line and statistics to verify the first regression is run

correctly (with the correct variable and independent variable) will also be included. All of the

analysis is done using Excel.

All data used for this analysis is downloaded from the EDGAR SEC and the Yahoo

Finance website. Upon arrival to the webpage, the S&P 500 data can be found by clicking on the

“S&P 500” icon, followed by clicking on the “Historical Prices” icon. Click on the monthly

indicator to download monthly data and enter in the dates that are needed. For this, analysis we

downloaded sixty-one monthly observations to calculate sixty monthly returns. The data columns

are: Date, Open, High, Low, Close, Average Volume, and Adjusted Close. The index and the

PepsiCo price are adjusted for splits and dividends. Next, move the cursor to the bottom of the

data and click on “Download to Spreadsheet”. Save the data to a spreadsheet and repeat the

process for the PepsiCo data. Begin by entering the PepsiCo ticker symbol (PEP) and proceed to

download and save the data for the specific time period.

36

Calculating Returns for the S&P 500 Index and for PepsiCo

To compute the beta coefficient, arithmetic returns are used. Arithmetic returns are

calculated by dividing the ending index or stock value (Value1), by the beginning value (Value0)

and subtracting one, as in

Equation [5-1]. An alternative method to calculate the return is to subtract the beginning value (

Value0) from the ending value (Value1) and dividing by the beginning value (Value0), as in

Equation [5-2]. Both returns are adjusted for dividends and stock splits. The returns used in the

regression analysis are arithmetic returns.

Return = [(Value1-Value0) – 1] [5-1]

Return = [(Value1-Value0)/Value0)] [5-2]

Calculating Beta for PepsiCo

The Modern Portfolio Theory illustrates that investors not rewarded for the total risk of

an investment but for the systematic risk. This is because total risk includes those that are firm-

specific and that can be eliminated in a well-diversified portfolio. The regression line between

the monthly returns for the individual security and the market index, which is also the slope

coefficient, shows the specific risk of an individual stock. The coefficient lines are calculated

using a sixty month regression. In this analysis, the beta coefficient for PepsiCo is calculated

37

using sixty monthly observations of returns from 01/03/2004 to 01/03/2015 and returns for the

S&P 500 Index for the same time period. Beta is the covariance between returns for PepsiCo and

returns for the S&P 500 divided by the variance for the S&P 500.

RPEP = AlphaPEP + BetaPEP(RM) [5-3]

Where,

RPEP The return for PepsiCo stock

BetaPEP The slope of the regression line between returns for the market and returns for

PepsiCo

AlphaPEP The intercept coefficient for the regression line between returns for the market

and returns for PepsiCo.

RM The return on the S&P 500 Stock market Index

(RM– RF) the market risk premium is the additional return that stock holders receive for the

additional risk of holding stocks rather than the risk free asset, long-term

government bonds.

The following table contains the data used to compute the PepsiCo beta and are downloaded

from the yahoo finance website. Column 1 shows the date and Columns 2 and 3 contain the

stock split and dividend adjusted index and price values for the S&P 500 Index and for PepsiCo

stock, respectively. The independent variable is the return for the S&P 500 and the dependent

variable is the return for PepsiCo. The returns are calculated by dividing the ending index or

stock value by the beginning value and subtracting one. An alternative method to calculate the

return is to subtract the beginning value from the ending value and dividing by the beginning

38

value. Both returns are adjusted for dividend and stock splits. The returns used are arithmetic

returns.

In this paper, the CAPM is used to compute the required rate of return for PepsiCo. The

required rate of return for PepsiCo is the minimum rate of return demanded by stockholders of

PepsiCo stock. The model used in this paper is based on the CAPM derived from the work of

Sharpe (1964).

RPEP = R f + BetaPEP (Rm –RF)

[5-4]

RPEP= the required rate of return for PepsiCo Stock

R f = the risk free rate of return

BetaPEP= the beta coefficient for PepsiCo

Rm= the rate of return on the stock market

(Rm – RF) = the market risk premium

The required rate of return for PepsiCo is the risk-free rate of return plus the risk

premium. The risk premium is the beta for PepsiCo times the market price of risk.

39

Using an Excel spreadsheet to create it, the table below contains the regression results for

the regression between the return for the S&P 500 and for PepsiCo. The independent variable is

the return for the S&P 500 (X-axis) and the dependent variable is the return for PepsiCo (y-axis).

Both returns are adjusted for dividends and stock splits.

The regression graph is a graph of the data used to compute the PepsiCo beta, which is

the characteristic line for PepsiCo and was created using the chart function in Excel. The

independent variable is the return for the S&P500 (x-axis) and the dependent variable is the

return for PepsiCo (y-axis). Both returns are adjusted for dividends and for stock splits. The

chart contains the trend line andR2. The statistics in the graph are the same as the regression

statistics in Table 5-1. The purpose of the graph is to ensure that the regression was run with the

40

correct independent and dependent variable. If the trend line and statistics in the graph are not

identical to the numbers in the regression, the variables may have been reversed.

Calculating the Required Rate of Return for Stocks

In this paper, the CAPM is used to compute the required rate of return for PepsiCo. The

required rate of return for PepsiCo is the minimum rate of return demanded by stockholders of

PepsiCo stock. The model used in this paper is based on the CAPM derived from the work of

William F. Sharpe (1964).

RPEP = R f + BetaPEP (Rm –RF)

[5-4]

RPEP= the required rate of return for PepsiCo Stock

R f = the risk free rate of return

BetaPEP= the beta coefficient for PepsiCo

Rm= the rate of return on the stock market

(Rm – RF) = the market risk premium

The required rate of return for PepsiCo is the risk-free rate of return plus the risk

premium. The risk premium is the beta for PepsiCo times the market price of risk.

Calculating the Required Rate Return for PepsiCo Using the CAPM

The risk free rate is the total return (income plus capital appreciation) on Long-term

Government Bonds taken from SBBI 2007. For the years from 1926 to 1976, SBBI used the

41

Government Bond File from the Center for Research in Security Prices. For the period from

1976 to 2006, the returns in SBBI 2007 are computed from data taken from the Wall Street

Journal. The yield for the bond is the discount rate that equates the expected future cash flows,

coupon payments and maturity value, to the current price.

SUMMARY OUTPUT

Regression StatisticsMultiple R 0.464910476R Square 0.216141751Adjusted R Square 0.202626953Standard Error 0.030304661Observations 60

ANOVAdf SS MS F Significance F

Regression 1 0.014687503 0.0146875 15.9929701 0.000182247Residual 58 0.053265602 0.0009184Total 59 0.067953106

Coeffi cients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.005970085 0.004082312 1.4624274 0.14902192 -0.002201551 0.01414172 -0.002201551 0.014141721X Variable 1 0.42139 0.1054 3.9991212 0.00018225 0.210467675 0.63231212 0.210467675 0.632312122

42

References

1. McGowan, Carl B., Jr. Corporate Valuation Using the Free Cash Flow Method Applied

to Coca-Cola. N.p.: n.p., n.d. Print.

Chapter 5: Free Cash Flow to Equity

Corporate financial management is used to maximize the value of the firm, where, the

value of the firm is measured by the market capitalization of the company. The market

capitalization of the company is calculated by multiplying the total number of shares outstanding

by the market price per share. The value of the company is also determined by the risk and return

characteristics of the company which is determined by the decisions of the corporate financial

managers. Therefore, a company that has a goal of higher rates of return would assume higher

risk responsibilities and invest in an industry such as oil fracking. Similarly, a company that

takes lower risks would be forced to accept lower rates of returns and invest in an industry like

money market management such as T bills.

Decisions made by financial managers fall under three categories: investment decisions,

financing decisions and dividend decisions. Investment decisions determine the types of assets

that should be purchased and directly impacts the relationship between current assets and fixed

assets. Higher ratios of current assets to fixed show less risk of default or insolvency. Lower

return on assets and return on equity results from a high current ratio. Financing decisions are

related to how the company uses fixed cost sources of funding (i.e. long-term bonds). The greater

the financial leverage of a company, the higher the returns on equity are expected to be. The

43

dividend decision involves the allocation of funds; even though it is not an asset decision, it does

affect the financial leverage.

The distribution of future cash flows, which is a decision maker’s estimate, is based on

accounting information that is provided by financial managers. The probability distribution of

expected cash flows is used to determine the total market capitalization (value) of the company.

Higher expected cash flows along with lower required rates of return equate to a higher value

company.

Valuing a Share of Stock Using the Free Cash Flow Model

A stock’s value is determined by the future free cash flow to equity (FCFE).

P0=¿¿ FCFE1 + FCFE2 + FCFE3 + …….. [6-1]

However, since the Free Cash Flow to Equity is in the future, each Free Cash Flow to Equity

must be discounted to the present time by the cost of equity (k).

Therefore,

P0=¿¿ FCFE1

(1+k )1 +

FCFE2

(1+k )2 + FCFE3

(1+k )3 + ………

[6-2]

The discounted present value of the future stream of Free Cash Flow to Equity discounted at the

cost of equity can be represented as: the sum of each Free Cash Flow to Equity (FCFEt)

discounted by one, plus the cost of equity (1+k )t, from time zero to time infinity.

P0= FCFEt/(1+k )t [6-3]

44

If we assume that the future Free Cash Flow to Equity will grow at a constant rate (g), each

future Free Cash Flow to Equity is equal to the Free Cash Flow to Equity at time zero times one,

plus the growth rate raised to the power of t. FCFEt = FCFE0 (1+g)t. We can substitute this

value of FCFEt into formula [6-3].

P0 = FCFE0 (1+g)t/ (1+k )t [6-4]

If g and k are constant and k is strictly greater than g, Equation [6-4] can be simplified to

Equation [6-5]. That is, the value of an investment is equal to the anticipated Free Cash Flow to

Equity at time t=1 discounted at the cost of equity minus the growth rate.

P0= FCFE1/ (k - g) [6-5]

That is the value of a share of stock in the firm is equal to the anticipated future dividend divided

by the required rate of return for equity minus the expected future growth rate of FCFE for the

firm. This model assumes that FCFE will be greater than zero and that k is strictly greater than g.

The Super-Normal Growth Model

The super-normal growth period is the time period where the growth rate will be above

average. After the super-normal growth period, the growth of the company returns to the long-

term growth rate of the economy (based on the GDP). The present value of the shares in the firm

is equal to the discounted present value of the Free Cash Flow to Equity (FCFEt) for the super-

normal growth period, plus the present value of the future Free Cash Flow to Equity for the

normal growth period. The practice for company valuations is to compute five years of super-

normal growth and then assume a constant long-term growth rate.

45

P0=¿¿ FCFE1

(1+k )1 +

FCFE2

(1+k )2 + FCFE3

(1+k )3 +

FCFE4

(1+k )4 + FCFE5

(1+k )5 +

P5

(1+k )5

[6-6]

The Free Cash Flow to Equity values for years 1 to 5 are computed using the super

normal growth rate ( g*) and the Free Cash Flow to Equity for year six is computed using the

long-term normal growth rate,(g). FCFE1 is equal to the value of FCFE0 times the growth factor

[FCFE0 ¿. FCFE2 is equal to the value of FCFE1 times the growth factor [FCFE1 ¿]. The rest of

the Free Cash Flow to Equity values until FCFE5 are computed using the super-normal growth

rate. FCFE6 is equal to the value of FCFE5 times the normal growth rate, FCFE5 ¿.

FCFE1 = FCFE0 ¿ [6-7]

FCFE2 = FCFE1 ¿ [6-8]

FCFE3 = FCFE2 ¿ [6-9]

FCFE4 = FCFE3 ¿ [6-10]

FCFE5 = FCFE4¿ [6-11]

FCFE6 = FCFE5 ¿ [6-12]

After time = 5, it is assumed that the firm will return to a normal long term growth rate that is

constant. The terminal value of the investment at time = 5 is the discounted present value of all

of the future Free Cash Flow to Equity, beginning with Free Cash Flow to Equity six. The

terminal value (P5) is equal to the discounted present value of all of the future FCFE. Beginning

withFCFE6, the future cash flows are assumed to grow at a constant rate (g).

P5 = FCFE6 / (k-g) [6-13]

46

After the future Free Cash Flow to Equity values are computed for years one to five and the

terminal value at time five is computed, each cash flow is discounted to the present time (t=0).

The future cash flows are discounted at the cost of equity (k), and discounted for the number of

years in the future that the cash flow will be received.

PV (FCFE¿¿1)¿ = FCFE1 ¿ [6-14]

PV (FCFE¿¿2)¿ = FCFE2 ¿ [6-15]

PV (FCFE¿¿3)¿ = FCFE3 ¿ [6-16]

PV (FCFE¿¿ 4)¿ = FCFE4¿ [6-17]

PV (FCFE¿¿5)¿ = FCFE5 ¿ [6-18]

PV (P¿¿5)¿ = P5/¿ [6-19]

Hence, the present value of the investment is equal to the sum of the six present values of the

future Free Cash Flow to Equity and the future terminal value.

P0=PV (FCFE ¿¿1)¿ + PV (FCFE¿¿2)¿ + PV (FCFE¿¿3)¿ + PV (FCFE¿¿ 4)¿ +

PV (FCFE¿¿5)¿ + PV (P¿¿5)¿

Free Cash Flow to Equity

In this analysis, the super-normal growth rate model is combined with the free cash flow

to equity model. In the FCFE model, FCFE is defined as net income minus net capital

expenditures minus the change in working capital plus net changes in the long-term debt

position. Net income is taken from the income statement. Net capital expenditure equals capital

47

expenditures minus depreciation; and are both derived from the statement of cash flows. The

change in working capital is the difference of accounts receivable plus inventory from one year

to the next minus the difference in accounts payable from one year to the next.

Therefore,

FCFE = NI – (CE-D) – (Δ WC) + (NDI-DR) [6-21]

Where,

FCFE Free Cash Flow to Equity

(CE-D) Net Capital Expenditures

(Δ WC) Changes in non-cash working capital accounts: accounts receivable, inventory,

payables

(NDI-DR) New debt issues are a cash inflow while the repayment of outstanding debt is a

cash outflow. The difference is the net effect of debt financing on cash flow.

NI Net Income

CE Capital Expenditure

D Depreciation

Δ WC Change in Working Capital

NDI New Debt Issued

DR Debt Retired

48

Computing Free Cash Flow to Equity for PepsiCo (2005-2014)

Table 1 shows the computation of FCFE for PepsiCo for the period of 2005 to 2014.

This was done using the data from PepsiCo’s 10-K forms for the time periods. Net income was

derived from the income statement. Capital expenditure is the difference between purchases of

Property, Plant and Equipment and Depreciation taken from the Statement of Cash Flows). The

change in working capital for each year is calculated by taking the difference in each of the

working capital accounts for each year from 2005 to 2014. Working capital accounts include

accounts receivable, inventory, and accounts payable. The change in working capital is defined

as the net change in accounts receivable plus inventory minus accounts payable. When net

income, depreciation, capital expenditure and the change in working capital are combined we

have FCFE before changes in debt. Net cash flow from debt equals new debt financing minus old

debt retirement, which is added to FCFE before debt to compute FCFE after debt.

Table 1

49

Year NI Dep

Cap

Exp

Change

(WC)

FCFE(BD

)

NCFT

D

FCFE(AD

)

2005 4,078 1,308 -1,648 404 4,142 -152 3,990

2006 5,642 1,406 -2,019 -172 4,857 -106 4,751

2007 5,658 1,426 -2,383 78 4,779 1589 6,368

2008 5,142 1,543 -2,070 145 4,760 831 5,591

2009 5,946 1,635 -2,348 -183 5,083 3070 8,153

2010 6,338 2,327 -3,172 343 5,836 5892 11,728

2011 6,462 2,737 -3,255 -210 5,734 633 6,367

2012 6,214 2,689 -2,619 263 6,547 3500 10,047

2013 6,787 2,663 -2,686 909 7,673 301 7,974

2014 6,558 2,625 -2,744 1032 7,491 1666 9,157

            Avg 7,413

Chapter 6: Valuing PepsiCo

This chapter of the analysis illustrates how calculations were done to determine Free Cash Flow

to Equity for PepsiCo. It was done using the input data collected from Chapter 3 to Chapter 5.

Column 1 Year for which FCFE is estimated from 2015 to 2020

Column 2 Projected Free Cash Flow to Equity for years 2015 to 2020 (assuming a

growth rate of 18.76% from Chapter 3

Column 3 Present Value of FCFE for years 2015 to 2020 discounted at the required

rate of return for equity for PepsiCo of 4.95%

50

PEP 8.49%g(GDP) 3.55%(k-g) 4.95%g* 0.1786

Year FCFE PV(FCFE)Average 7,413

2015 8736 80532016 10297 87482017 12136 95032018 14303 103242019 16858 11216

2020 352884 277199Total 325043

When we value a stock that has a period of super-normal growth, that value of the equity

is the discounted present value of the expected free cash flow to equity during the super-normal

growth period plus the terminal value of the stock at the end of the super-normal growth period.

In valuing PepsiCo, it is assumed that the super-normal growth period will last five years. This

is standard in the valuation industry because projections beyond five years are very uncertain.

The value of the stock at the end of the super-normal growth period is the discounted present

value of all of the future free cash flow to equity and is computed from theP5= FCFE6/ (k-g).

The difference is that the present value of a share of stock at time=t is equal to the anticipated

free cash flow to equity at time= (t+1). Beginning with time= (t+1), the investment returns to the

long-term growth rate with both (k) and (g) becoming constant and (k) being strictly greater than

(g). Since we are using a super-normal growth period of five years, the terminal value of the

stock is

51

P5= FCFE6/ (k-g). The value of it is five years into the future and must be discounted to the

present using the cost of equity.

Conclusion

In this analysis, the concepts of equity valuation, super-normal growth, required rate of

return on equity and sustainable growth were combined to determine the market value of

PepsiCo (PEP). The value of the equity of a firm is defined as the present value of all future cash

flows from the firm to the shareholders. The value of the firm is FCFE divided by the sum of the

required rate of return for equity minus the growth rate of the firm’s earnings. Free Cash Flow to

Equity is defined as net income minus net capital expenditures minus the change in net working

capital plus the net change in long-term debt financing. The required rate of return for equity is

computed using the CAPM using a five-year monthly rate of return beta relative to the S&P 500

Index. Sustainable growth for the super-normal growth period is computed with the extended

DuPont model. The long-term growth rate is assumed to be the same as the growth rate of the

economy.

Works Cited

52

"The History of Pepsi-Cola." The History of Pepsi-Cola. Leader Distribution Systems, Inc., 2012. Web.

20 Oct. 2015.

"Journey: A Glimpse Into The History of Pepsi Bottles." Bottle Bonanza. Bottle Bonanza, 28 Nov.

2010. Web. 20 Oct. 2015.

McGowan, Carl B., Jr. Corporate Valuation Using the Free Cash Flow Method Applied to Coca-Cola.

N.p.: n.p., n.d. Print.

McGowan, Carl B., Jr., John C. Gardner, and Susan E. Moeller. The Fundamentals of Financial

Statement Analysis as Applied to the Coca-Cola Company. New York City: Business Expert,

2015. Print.

"Pepsi Store - History of the Birthplace of Pepsi." Pepsi Store - History of the Birthplace of Pepsi.

Pepsi Store, n.d. Web. 20 Oct. 2015.

53