The 3 Keys to Pepsi's Returns

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, Pepsi (NYS: PEP) .

Pepsi shares returned 63% over the past decade. How'd they get there?

Dividends pulled about half the weight. Without dividends, shares returned 31% over the past 10 years.

Earnings growth was fairly strong. Pepsi's normalized earnings per share grew at an average rate of 10.2% a year for the past 10 years. That's above the broader market average, and an impressive return for a company as mature and large as Pepsi. Most of the gain was fueled by growth in international sales, and part was due to a reduction in the number of shares outstanding.

But if earnings growth was so strong, why were returns so meager? This chart explains it:


Source: S&P Capital IQ.

Pepsi's valuation multiple has collapsed by roughly half over the last 10 years. Put simply, the market doesn't value its earnings as much as it did in the past. The same has been true for rival Coca-Cola (NYS: KO) and other consumer companies like Procter & Gamble (NYS: PG) and Johnson & Johnson (NYS: JNJ) .

A big driver of the valuation decline is that shares were overvalued 10 years ago -- the compression since then has mostly been a return to normal. In that sense, the relatively poor returns of the past decade were already sealed long ago. Those who bought Pepsi shares at 35 times earnings were guaranteeing themselves low returns. The good news is that, at 16 times earnings, shares now look fairly valued. Going forward, more of the company's earnings growth should come through to shareholder 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.

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At the time this article was published

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