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Author: TMFSysun Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 2674  
Subject: Re: Pepsi Write-Up Date: 7/17/2009 7:48 PM
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Aaron, great write-up again! TMFGebinr tells me you're still quite young--I wish I had been so focused at such a young age.

I wanted to comment on this:


Profit Margin-
Coke- 18.2%
Pepsi- 11.9%

Operating Margin-
Coke- 26.4%
Pepsi- 16%

ROE-
Coke- 27.4
Pepsi- 42.7


First of all, it's great that you understand the importance of these metrics in context. No company operates in a vacuum, and a wise-man once said (probably) that a company is only as successful as its competitors allow it to be. I want to comment in particular on the ROE figures.

You'll notice that Coke has better margins than Pepsi at both the net income level as well as the operating income level, which means Coke is doing a better job of cutting its operating expenses--it's running a more efficient company.

ROE is generally a great indicator of management efficiency as it measures the returns (profit) that the management is able to earn with a certain amount of equity. An ROE of 27.4%, for Coke, for instance, suggests that for every $1 of equity, the management at Coke can eke out 27.4 cents. An ROE of 42.7% means Pepsi is squeezing out 42.7 cents of profit for each $1 of equity--significantly better than Coke! This suggests that Pepsi is a much, much better managed/operated company, even though the margin levels suggest otherwise!

The reason for this contradiction is because ROE gets artificially inflated if a company has a high level of debt relative to its assets. A better indicator of management efficiency and operating ability is the ROC (Return on Capital), which is calculated as Net Income / Total Capital. Total Capital is often calculated as Total Equity + Total Debt. Debt is important to consider in understanding a business because even though eventually the company will have to return the money, in the meantime, they've used it to their advantage.

Now let's take a look at how Coke and Pepsi line up:

ROC
Coke - 19.1%
Pepsi - 24.5%

The returns are much closer, and even though Pepsi still seems to earn more profits for each $1 it uses, it seems that both are quite well-run. Remember, though, that these metrics are only guides. Further digging is going to be required to understand exactly why Coke is better than Pepsi in getting higher margins and why Pepsi is better than Coke in earning higher returns on capital. From the numbers alone, it's hard to tell which is the better company.

Anyway, keep up the great work Aaron, I really look forward to your next posts!

-sys
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