Coca Cola Residual Income Valuation Case Study Analysis

Case Overview

The case is regarding the usageof the residual income valuation model of Coca-Cola. This report explains the valuation that the company is using, discounted cash flows, residual income, the value per share, market history, marketing strategies, market positioning and the other information related to Coca-Cola. In this report, sales have been forecasted and the performance of the company is discussed from its financial position.

Residual Income Valuation

Several methods are being used by the companies to create value for its common stock. These are different methods, which highly differ from one another but they calculate the value of the stock. Here, net income does not show the economic profit of the company, and also when the company shows the profits; these profits can be economically lost after the consideration of equity cost. Discounted cash flow is also a tool for valuation, which is used by Coca-Cola. The residual income valuation or residual income model is the valuation of equity, which is based on the idea that the present value of future residual income equals the company’s stock that is discounted at the suitable cost of equity. It is an absolute valuation method but it is not familiar to most of the people, but there isa majority of the analysts who use this valuation method. This method has the assumption that the earnings or income generated by the company should account for the true cost of capital, in other words;the cost of debt and cost of equity. (Chandra)

The residual income is an idea of the rate of return required by the investor from their resources, which are under the company’s management. This provides compensation for their opportunity cost. The return is said to be the cost of equity and the formal equity cost has to be subtracted from the net income of the firm. For creating the shareholders’ value; the company should be capable of generating returns. Is these returns are not more than the cost or investment then they should be equal to the cost. It is normal if the value is negative, but it is positive when the company applies a discounted cash flow approach.

Importance of Residual Income valuation

There are many benefits associated with this valuation method, because of which this model is useful and important. The valuation method is better for mature organizations that do not allow dividends and they allow following the random patterns of dividend payments. So the residual income model is a viable option to the DDM or dividend discount model. This model is also used by the companies having negative cash flows. As a discounted cash flows model; this model of valuation is also used and recognized. The calculation of the model is not tricky and can be done by the following steps:

Calculation of Residual Income

The residual income can be calculated to determine the intrinsic value of the company’s stock. The residual income can be computed by the difference between the equity charge and net income. The formula can be:

Residual Income = Net Profit – Equity Charge

The equity charge can be computed as:

Equity Charge = Equity capital * cost of equity

The residual income is calculated by putting the values in the excel sheet. The residual value is calculated by the cost of equity, net income and charge for common equity. The cost of common equity for 2011 and 2012, is calculated by the market risk premium, risk-free rate and common equity beta. Net income is calculated by income statement and charge of common equity is calculated by common stock equity and multiplying it bythe cost of common equity. The residual income is 12,248.35. This value is calculated by net income and subtracting the charge of common equity. (Coca-Cola: Residual Income Valuation, 2012)

Value per Share

Cost or value per share is the value of the investor’s investment amount, which is extracted by dividing it with the number of shares. It is a more common technique, which is also known as the net asset value. It is the price of the share on which it is bought and sold. It is calculated with the closing prices of the day of trading. This value of the share should be the same as the total of individual security. This also refers to the value of a single share. The book value and market value per share are some of the techniques for evaluating the common stock value. Market prices per share show the current prices and its expected prices of the investors for a company. There are certain types of value per share. Investors can use value per share to see the difference in the prices of the company’s stock and value of the business. The investors, when they want to invest; see the large differences between the two numbers, to buy and sell. (Eugene F. Brigham)…………………………

 

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