So, what went wrong in the Cadbury Schweppes valuation? There are basically two possible explanations. The first explanation is that the stock market valuations—either of CSG or KO, or both—are just plain wrong. In this case, it makes little sense to use the methods of comparables. But this scenario is unlikely. If the market values were systematically wrong, you could presumably easily get rich if you purchased undervalued firms. If it is not obvious, the nest series of posts will explain why getting rich is not easy—and which is why only about half of all investors beat the market—so we will assume that misvaluation is not the principal reason. The second explanation is that your assumption that the two firms were basically alike is incorrect. This is the more likely cause. There is a long litany of reasons why comparables are not really comparable, and why the technique failed you in valuing Cadbury Schweppes. Here is an outline of possible problems, on which the remainder of this series of posts focuses:
Problems in Selecting Comparable Firms Comparing businesses is almost always problematic. Every firm is a unique combination of many different projects. Cadbury Schweppes owns Dr. Pepper, 7-Up, A&W Root Beer, Canada Dry, Hawaiian Punch, Snapple, Mott’s Apple products, Clamato juice, plus some confectionary brands. This may not be comparable to Coca Cola, which owns Coca Cola Bottling, Minute Maid, Odwalla, and some other drink companies. Each of these businesses has its own profitability and each may deserve its own P/E ratio.
Even for the main business, as any soda connoisseur knows, Pepsi Cola and Coca Cola are not perfect substitutes. Different consumer tastes may cause different growth rates, especially in different countries.
Maybe as a British firm, Cadbury Schweppes uses altogether different accounting methods.
Maybe Cadbury Schweppes has just had an unusual year, or a year in which it plowed most of its cash into advertising, thereby causing unusually lower earnings for now and much higher earnings in the future.
If you did not use earnings from the most recent four quarters, but instead forecast earnings over the next four quarters, maybe the numbers would then be more comparable.
Tags: accounting, mortgage, profitability, valuation