A Surprisingly Good Return on a Scary Day

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Just as we're moping along, wondering what made the value of our equity investments shrink 20%, a ground-shaking event helps us put a more relevant appraisal on those (hopefully, just paper) losses. I'm talking about the earthquake that rattled much of the eastern U.S. on Tuesday.

But after my house stopped shaking like crazy, and after a few reassuring phone calls to my family, it was time to get back to work. I decided it would be a good time to put some "context and perspective" -- as a network news anchor used to say -- on a couple of companies that seem very similar on the surface but turn out to be worlds apart in terms of a very important financial metric.

I'm talking about Coca-Cola (NYS: KO) and PepsiCo (NYS: PEP) , two icons of American branding, two examples of what are thought to be solidly run, profitable companies that have paid back their investors with decent growth in value and in dividends.

A meaningful metric: Part 1
To compare these companies in a relevant way, I decided to use a metric called return on invested capital, or ROIC. It's a tool used by many of my fellow Fools to get a clearer picture of how well a company uses its capital resources, the money it has received from its shareholders and lenders.

ROIC is found by dividing a company's net operating profit after taxes by its invested capital. Invested capital is derived by taking the company's total assets and subtracting all cash and cash equivalents, and all non-interest bearing delayed payment liabilities -- accounts payable, for example. A more detailed explanation of ROIC can be found here.

A meaningful metric: Part 2
But to really put that ROIC into perspective, we need to know just how much that invested capital costs in the first place. That's where weighted average cost of capital, or WACC, comes in, but it's a bit more complicated to calculate.

Basically, the equation used to compute WACC averages the different amounts of equity and debt the company holds, and the price for each -- what the stockholders expect in return for their investments -- and the interest rate on the debt. More detail on WACC can be found here.

The difference engine
The spread is what's important here, the difference between the ROIC and the WACC.

Because I am going to value large, blue-chip, established companies here, I am going to plug in a long-term debt interest rate of 6% and the historical average stock market return of 10.5% into my WACC formula.

Remember, startups without a long history of profitability would most likely have to pay a higher interest on their debt. Likewise, investors in such companies would also want a higher return for the greater risk they are taking.

Here are the results, with a couple of other competitors thrown in for a bit more perspective.

Company

ROIC

(TTM)

WACC

Spread

Pepsi12.2%9.3%2.9%
Coke14.1%10.1%4.0%

Dr Pepper Snapple Group

(NYS: DPS)

8.9%8.9%0%

Kraft

(NYS: KFT)

5.9%8.6%(2.7%)

Sources: Company statements, author calculations; TTM = trailing 12 months.

And the winner is ...
Pepsi's return is certainly decent enough, and the spread between its ROIC and WACC isn't bad, either, even if it doesn't knock your socks off. Frankly, though, I was hoping that spread between return and cost would have been wider. Especially, since I own shares in Pepsi.

Coke's numbers are even better, a very solid 14.1% ROIC. The company sure seems to know what to do with what it's got, capital-wise. I knew there had to be a good reason Warren Buffett holds the company in such high esteem. As a matter of fact, ROIC is also a favorite metric of Buffett's.

On the other hand, a flat or negative spread, as shown by Dr Pepper and Kraft, is an indication that those companies are having problems in using their capital in the best way.

If you take one thing away from this...
Investors should not rely on just one metric when it comes to investment choices. But using the right tool, such as ROIC, can help keep those choices framed in a useful way. Right now I'm looking at my investment in Pepsi in a new light. Frankly, it's tasting a little flat about now compared with Coke.

At the time this article was published Fool contributorDan Radovskyowns shares of PepsiCo. The Motley Fool owns shares of PepsiCo and Coca-Cola.Motley Fool newsletter serviceshave recommended buying shares of PepsiCo and Coca-Cola, as well as creating a diagonal call position in PepsiCo. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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