Totaling Coke's yield (2.4%), profit growth (5.2%), and excess earnings yield (1.2%) produces an expected total return of 8.8%. It's important to note that this total return projection is contingent on the current stock price--we can expect an 8.8% annual return from Coke only if we acquire the shares at $45. If we pay less, our total return will be higher, and vice versa.
For example, let's say the market hits the proverbial banana peel, and Coke is offered at $35. Meanwhile our expectations (current earnings, dividend rate, future growth) haven't changed. Our core growth projection (5.2%) remains, but our two other factors are contingent on the stock price: At $35 the stock will yield 3.1% and our excess earnings quotient will rise to 1.6%. Our expected total return is now 9.9%, more than a full point higher. Conversely, if we wind up paying $55, our total return prospects are substantially reduced. Coke's yield will fall to 2%, the excess earnings quotient to 1.1%, and our expected return to 8.3%.
This analysis essentially calculates fair value in reverse--instead of using a required rate of return to yield a fair price for the stock, we use the stock price to calculate the shares' total return. Coke's fair value is the price at which its total return is equal to the return we would require for any stock of similar risk characteristics. Morningstar's fair value estimate in mid-2005 for Coke was $54, which was calculated using an 8.5% cost of equity--a return virtually identical to our total return projection if we use $54 as the stock's price.
What's the "right" required rate of return? Unfortunately there's more art than science to this, but we have two observations. First, over a very long period of time (200 years), the market has managed to return something around 10%. Lower-risk stocks would offer less, while higher-risk situations should require more. But most established, dividend-paying companies would fall in a range between 8% and 12%. Whatever you determine a "fair" return to be, demand more. This way you have a margin of safety between your assumptions and subsequent realities.
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