Avoid PEP due to stagnant free cash flow and excessive payout ratio preventing sustainable growth.

Now, we have Pepsi stock, a stock I've been very critical of over the last couple of years. I've warned investors of the potential issues that are looming with this stock, the issues that are currently going on, and as a result, we can see those issues have come to fruition, and the stock is at a 52-week low.

In fact, the 5-year returns now for Pepsi are minus 11%, which is mind-blowing to think about for a stock that is this much of a staple in our economy. But, that's the reality that we're looking at right now.

Now, the thing is, trading at these prices is they're at one of their lowest valuation multiples in the last 5 years, with a PE multiple of just 15.95, where the average is 21.3, and all of a sudden, the stock is yielding quite a bit more than it historically has.

The stock is yielding well over 4% at this point, and again, this is another dividend king stock with over 50 consecutive years of dividend increases, and a 10 and 5-year dividend CAGR of over 6%.

So, when you consider the historic dividend growth, the nice starting dividend yield, and the historical high levels of dividend growth, on the surface level, that looks like an incredibly attractive dividend opportunity.

But, if you stopped your analysis right there, you would be missing some absolutely critical insights.

And let me show you what I mean. To start, let's jump over to our free cash flow sheet. I don't want to just look at the free cash flow sheet, but I want to take a much deeper dive into what the actual free cash flow metrics for this stock look like.

And let me show you why. We'll go ahead and plug in the ticker Pepsi. Now, what we're looking at here is relatively simple. It's operating cash flows, capital expenditures, and remember, operating cash flow minus capital expenditures equals free cash flow.

And free cash flow is the ultimate driver of intrinsic value. If free cash flow is growing, then a stock can grow its dividends. It can buy back shares. And ultimately, it can reinvest back into the business, which will push the share price higher.

So, free cash flow is essentially our golden metric. Now, what we'll notice is from 2015 to 2025 for Pepsi, free cash flow actually has stagnated. It hasn't seen any growth whatsoever. So, obviously, that's the first major concern.

Now, one of the things we can see though is operating cash flows have grown. So, the cash flows the core business is generating, yes, that's grown, but capital expenditures have grown.

Now, we started to see a pullback in CapEx in 2025, so that's a good sign. But, take a close look at what's going on with their dividends. With free cash flow at 7.6 billion, what we can see is in 2025, yes, free cash flow at 7.6 billion, but dividends was also 7.6 billion.

So, this company used all of their free cash flow to pay out dividends.

Now, keep in mind, when it comes to capital allocation, there's five options. I hammer this home all the time, but it is one of the most important concepts that investors have to understand.

How can a company utilize free cash flow? Well, they can reinvest back into the business. They can attempt mergers and acquisitions. They could pay down debt, buy back shares, and pay out a dividend.

So, what does it mean if Pepsi's using 100% of their free cash flow to pay out dividends? Well, it means that they don't have capital left over to do those other options that I just mentioned.

So, ultimately, the question is, can Pepsi start growing free cash flow at a rate where they can start reinvesting back into the business, where they can easily cover those dividend payments, where they can start to buy back shares?

That's ultimately what everything hinges on for Pepsi.

So, what does their guidance look like? And I was writing about this over on dividendology.com, but there's three key takeaways. Organic revenue is projected to increase only between 2 and 4%.

So, that's essentially revenue growth in line with inflation, so ultimately, revenue is not growing at all. Now, they also stated they expect a free cash flow conversion ratio of at least 80%.

Now, what does this mean? Well, it's telling us what percentage of earnings they're actually translating into free cash flow. But, here's what's scary. If we jump back over to our free cash flow analysis and look at Pepsi, take a close look at this key metric when we zoom in.

We can see in 2025, free cash flow conversion was 93%. They're telling us that this year, it'll be closer to 80%. So, not only is organic revenue really not increasing any above the rate of inflation, but their free cash flow conversion ratio is going to be even lower over the next year.

So, both of these are going to make it very hard to ultimately grow free cash flow in 2026, but here's the biggest red flag of them all. Their total cash return to shareholders will be approximately 8.9 billion.

They're paying out 7.9 billion in dividends, which by the way, right now, free cash flow is not covering those dividend payouts, but at the exact same time, they're buying back 1 billion dollars worth of shares.

So, that's 8.9 billion of capital they're returning to shareholders, while free cash flow likely won't at least be much higher than it was in 2025. So, those are undoubtedly red flags that investors need to be aware of.

Now, ultimately, what does this mean for Pepsi in terms of valuation? Well, it's actually relatively simple. If we jump over to our valuation sheet, once we have Pepsi plugged in, jump over to our dividend discount model, and this starts to really paint the picture.

Even if Pepsi grows its dividend at one or even 2% moving forward, there is still significant downside for this stock. And the issue with this is right now, they can't grow their dividend.

They can't sustainably grow their dividend at least. They recently announced a 4% dividend increase, but they can only do that by weakening the balance sheet because they're using all their free cash flow to pay out dividends, to buy back shares.

Now, of course, this doesn't mean that Pepsi can't turn things around, but the capital allocation issues at Pepsi right now are very real. And that's enough to keep me away from this stock.

Now, this gives McDonald's some serious advantages, at least relative to most of their peers, because when you talk about a stock like McDonald's, again, let's use Pepsi as an example since we just looked at them.

On the surface level, you think there might be a lot of similarities, but that's simply not the case. McDonald's is much more recession-proof due to the new business model that they've implemented.