A Brief History of Coca-Cola's Returns

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Despite constant attempts by analysts and the media to complicate the basics of investing, there are really only three ways a stock can create value for its shareholders:                                                     

  1. Dividends.
  2. Earnings growth.
  3. Changes in valuation multiples.

In this series, we drill down on one company's returns to see how each of those three has played a role over the past decade. Step on up, Coca-Cola (NYS: KO) .

Coke shares have returned 95.6% over the past 10 years. How'd it get there?

Dividends accounted for about half of the total. Without dividends, Coke shares returned 51% over the past decade.

Earnings growth made up a good chunk, with normalized earnings per share growing at an average rate of 7% a year over the past 10 years.

But what really stands out is the change in Coke's P/E ratio:

anImage

Source: S&P Capital IQ.

Simply put, while Coke's earnings have risen substantially, the amount the market is willing to pay for those earnings has declined over the past decade. The same has been true for rival Pepsi (NYS: PEP) . Most of this is due to general market overvaluation 10 years ago -- at a lofty 35 times earnings in 2001, the multiple was bound to contract.

The question now is what happens going forward. Despite the slump, Coke shares aren't exactly cheap at a current multiple of 24 times normalized earnings. The company typically commands a premium multiple, and today's valuation seems to be near the high end of what investors should consider sustainable. This is still a high-quality company likely to generate consistent earnings growth going forward, but investors shouldn't expect any expansion of the earnings multiple to generate returns.

Why is this stuff worth paying attention to? It's important to know not only how much a stock has returned, but where those returns came from. Sometimes earnings grow, but the market isn't willing to pay as much for those earnings. Sometimes earnings fall, but the market bids shares higher anyway. Sometimes both earnings and earnings multiples stay flat, but a company generates returns through dividends. Sometimes everything works together, and returns surge. Sometimes nothing works and they crash. All tell a different story about the state of a company. Not knowing why something happened can be just as dangerous as not knowing that something happened at all.

At the time this article was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of PepsiCo and Coca-Cola. Motley Fool newsletter services have recommended buying shares of PepsiCo and Coca-Cola. Motley Fool newsletter services have recommended creating a diagonal call position in PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.                                                                                                                              

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