Coca Cola, one of the bluest of the blue chips. This is a foundational pillar of any portfolio. Through good times and bad times, Coke pumps out profits and generates wealth for its owners. It’s an easy business to understand: sugar water. It is a fantastic business. There is nothing quite like it. The returns generated by the selling of sugar water is incredible – consistent return on equity in the 20% range, which means loosely that for every dollar of sugar water Coke sells, they are able to generate 20ish cents of pure profit. But I’m not here to give you an in-depth analysis of Coca Cola today. Instead, I wanted to expand on how using the earnings yield can help you think about opportunity costs. Remember that post on how to think about an asset? Quickly peruse that again as it will be a useful primer for what I am about to go over.
To reiterate: the price you pay for an asset will entirely determine your rate of return. In this light, there is no poor asset per say, just poor prices to pay for an asset.
I vividly remember coming across many instances in my readings of Coca Cola at the height of the dot com bubble as an example of paying a terrible price for a fantastic asset; subsequently, paying this terribly high price doomed you to terribly low returns for the foreseeable future.
Why? Because by overpaying, your overpayment for your piece of ownership essentially “built in” the growth that was going to be coming into the foreseeable future. You cannot buy Coca Cola at ~P/E 50 (like it was at the height of the dot come bubble) and expect to do well.
Why? Because a large-cap company such as Coca Cola cannot grow fast enough to meet those levels of expectations. However, it’s an entirely different scenario with something like Starbucks at the beginning of their expansion – you could justify paying an astronomical P/E because Starbucks was growing so quickly in its younger days.
It’s like gravity: once you reach a certain size, your size effectively hampers you from achieving the explosive rates of growth from smaller, nimbler times. One more example to hammer this point home: since 1965, Berkshire Hathaway has grown per-share book value at a CAGR of 19.7%. However, over the last 5 years, it has only been able to grow per share book value at 11.1%. Buffett himself has stated:
“In the years since our present management acquired control of Berkshire, our book value per share has grown at a highly satisfactory rate. Because of the large size of our capital base (shareholders’ equity of approximately $222 billion as of December 31, 2013), our book value per share will very likely not increase in the future at a rate even close to its past rate.”
Anyways, back on Coca Cola and the earnings yield. I pulled a Value Line tear sheet of Coca Cola I have filed away in my cabinet. These are by no means precise figures, rather P/E averages and an approximation of stock prices and treasury yields. I think it is a close enough generalization to drive home the concept (pro tip: go figure out the precise figures if you are interested enough).
I chose 1998, 1999, 2000, 2001, 2007, 2008, 2009, 2010, and 2014 to show the differences in Coca Cola’s earnings yield vs. 30 Year US Treasury Bonds. Why these specific instances in time? 1998-2001 encapsulates the dot com bubble. 2007-2010 covers the housing bubble. 2014 is the full previous year of data available.
What I’ve done with the earnings yield of Coca Cola and the 30 Year US Treasury is to take the average monthly yield for each year presented below. For example, with the US Treasury yield, I sampled the yield at the beginning of every month and calculated the average yield for the year.
For Coca Cola, I used the data presented in Value Line to calculate the earnings yield based on their reported average P/E for the year and the EPS.
Here is a comparison of the earnings yield vs. the risk free rate for these instances in time (accompanied by a visual for all your visual learners out there):
Isn’t that just beautiful? I find it really incredible. Just incredible. Look at how far Coca Cola’s stock price advanced during the height of the dot com bubble: the average P/E for Coke was 51.3 in 1998 and 47.5 in 1999! This was a ~$150 billion market cap company at the dawn of the new millennium – a small, nimble, explosively growing company it was not. The insanity that was ensuing during the dot com bubble is just incredible to see in the data.
During this time, you would have been out of your mind to accept those piddly yields on Coca Cola stock when you could have gotten a risk free investment yielding you somewhere between 5-6% guaranteed, which was anywhere between 3-4% higher yield depending on when exactly you bought.
Sometimes, people forget that holding common stock entails risk, some of which include: the prospect of total loss, no guarantees of protection of principal, and no maturity date. By assuming these higher levels of risk, common stocks can (no guarantee) provide a higher potential return.
Like I finished off in the last piece on the earnings yield, every investor must come to terms with what risk premium they receive on their investment lets them sleep well at night. By using the earnings yield as a quick and dirty “back of the envelope” type of screener, it should help you get a general sense of how attractive (or unattractive) potential assets are.
For conservative starting investors, the earnings yield should eliminate almost every potential investment that comes across their desk. And that is a good thing, as sticking with investments that will give you the highest chance of success is a much more intelligent way to behave than, for example, buying Coca Cola at a 1.95% earnings yield in 1998 when a risk free investment yielded 3.58% more, guaranteed.
Personally, in a very general sense, I want there to be an adequate margin of safety between the earnings yield of a business and the risk free rate. I never want to go back to Go – that is an outcome I want to mitigate as much as statistically possible. This doesn’t mean I won’t choose investments that have a lower earnings yield vs. the risk free rate. But that’s a post for another day.
(I got really excited and just plotted out the rest of the years between 1998-2014, so here is a bonus graph)