Bearish on PEP due to unsustainable capital allocation where dividends consume ~100% of FCF; DDM fair value of $105 implies 26% downside.

Pepsi stock continues to be one of the most debated stocks among investors right now, and really it's been that way over the last couple of years. Ultimately, if we jump over to the dividend breakdown sheet and look at Pepsi, what you can see is the stock is yielding over 4%, which real quick for reference, if we look here on Seeking Alpha and look at the historical dividend yield, this is the highest dividend yield the company has seen in the last decade.

A much higher than normal starting dividend yield, a history of dividend growth over 50 consecutive years of dividend increases, with the 10 and 5-year dividend growth rates sitting roughly between 6% and 7%.

So, you can see why this immediately catches people's eye from a dividend perspective, and then when you look at the valuation, it's trading at its lowest valuation multiple in the last 5 years.

However, if you've been watching the channel for a while now, you know I don't personally own Pepsi in my portfolio. In fact, I've been outspokenly bearish on this stock over the last three or so years, and you can see the stock has not done well. In the last 5 years, down by about 8%.

And what's interesting is when you look at the historical valuation for these two stocks, we have Pepsi in the orange and then Coca-Cola in the green. Historically, they've traded at relatively similar valuation levels, but starting in around late 2023, early 2024, we started to see a wide divergence in the valuation multiples for these stocks.

Pepsi's now trading at a 16.6 PE multiple, while Coca-Cola is all the way up to 27 times earnings. That is a huge divergence in the valuation between these two stocks. Is that justified, or has Pepsi become a huge opportunity?

To start, let's break down some of the issues that Pepsi is currently facing. The dividend metrics at first glance do look quite attractive as we just pointed out, but the underlying issue is always capital allocation.

In 2025, Pepsi generated around 7.6 billion in free cash flow while dividends paid out was also 7.6 billion. So, the free cash flow payout ratio is 99.5%. They essentially used all of their capital to pay out dividends, and it doesn't get much better if we go back just a little bit.

Last year, the free cash flow payout ratio was at 100%. The year before that, a little bit better, 84, but in 2022, it was at 110%. So, we now have four consecutive years where essentially dividends are eating up essentially all of the free cash flow.

They're using all of their free cash flow to pay out dividends.

One of the things you'll notice is the company has been slightly buying back shares over the last few years. So, right off the bat, we know they're not only paying out dividends using again all of their free cash flow to pay out dividends, but they're also buying back shares.

What they're telling us is total cash returns to shareholders. That means dividends plus share buybacks is approximately 8.9 billion. 7.9 billion will be paid out in dividends with share re purchases at around 1 billion.

So, basically they have to generate 8.9 billion in free cash flow to cover all of their cash returns to shareholders.

So, if they're going to return to shareholders 8.9 billion in order to not weaken the balance sheet, to take on debt, they need to generate 8.9 billion in free cash flow, which for reference the company has never done before.

In fact, free cash growth over the past decade is slightly negative. It hasn't gone anywhere, which is obviously very concerning.

So, really the question we need to be asking above all other questions is can free cash flow start to grow again? Now, it's a very obvious question because that's the question we should be asking for every single stock we analyze, but particularly for Pepsi, strictly from a dividend sustainability perspective, it's a very important question.

If we jump over to the profitability sheet, the easiest way for a company to grow free cash flow is obviously to grow revenues. Now, the data will load in thanks to Ticker Data and you can see 5-year revenue growth is actually not too bad.

It's sitting at about 6%. However, in particular the last 3 years it's really started to stagnate. We've been sitting in the same range for about 3 years now.

Now, of course, if a company is stagnating revenues, they can still grow free cash flow by expanding their margins. Now, the gross profit margin hasn't expanded, but that's not the best indicator of really what the margins look like.

We need to be looking at free cash flow margins, which again we can do by jumping to the free cash flow analysis sheet and looking at Pepsi.

What they tell us is they expect to have a free cash flow conversion ratio of at least 80% in 2026. Free cash flow conversion, what is this telling us? Well, it's telling us what percentage of earnings are directly being translated into free cash flow.

So again, jump back over to the free cash flow analysis sheet and here's that metric right here. So in 2025, it was 93.11%. They're telling us that in 2026, it'll be at least 80%.

So technically it could be a little bit higher, but that's quite a bit lower than what we saw in 2025. So that's concerning.

Free cash flow margins are likely to be worse, combined with the fact that they're guiding towards organic revenue to increase by just 2 to 4% which again is essentially somewhat in line with inflation.

So really on a true real revenue growth basis, revenue's not growing at all. So this is concerning. We're not expected to see strong revenue growth, free cash flow conversion ratio should be lower, but at the exact same time, they plan to distribute 8.9 billion of capital to shareholders, but free cash flow likely won't be that high.

At least I don't see the path forward to hitting that level.

So my main concern with Pepsi again is purely capital allocation. People see that high starting dividend yield, the historic dividend growth levels in 50 consecutive years of dividend growth, and assume this is a great opportunity particularly when looking at that PE multiple at a 5-10 year low.

But the reality is these are all backwards-looking metrics. The issue for this stock is capital allocation.

Now they're doing things like attempting mergers and acquisitions like with Poppy for example to start to spur growth again, but again, that's going to weaken the balance sheet because they're not generating enough free cash flow to pursue these acquisitions because they're using all their free cash flow to pay out dividends.

Not to mention, they're currently dealing with a weakening consumer.

So, yes, I do have issues with Pepsi stock even at these prices because let me show you what valuation looks like even at these prices. Let's go ahead and jump over to our dividend discount model.

And here's my first issue with Pepsi, at least with their valuation right now. Again, we're valuing the stock based on how much they pay out in dividends and how much that dividend will grow in the future.

And we've already seen the difficulty they're going to have, not in just growing the dividend, but in simply maintaining the dividend over the next few years without really weakening the balance sheet.

So, with that in mind, if they grew dividends at about 3%, which to be honest could potentially be generous, even though it's lower than the historical dividend growth rates, their fair value would be around $105, implying 26% downside from current prices.

Now, Pepsi is one of those stocks that historically has been viewed as very defensive, and it's definitely AI-resistant, which means those are the types of stocks that tend to trade at a premium right now.

But, a lot of the market is starting to wake up to the fact that Pepsi's dividend metrics aren't what they used to be. Their capital allocation is not what it used to be, and even revenue growth in the margins are not what it used to be.

That's not to say that things can't turn around. But, when you look at this forward-looking guidance and look at it relative to what their capital allocation is currently looking like, you can see even in the next few years, there's still concerns for Pepsi stock.

So, again, this doesn't mean they can't turn things around. But, we always have to look at investments through the lens of a risk-to-reward scenario. And right now, the reward is not high enough for me to take on the risk of investing into Pepsi stock.

Even at this valuation level, a historically low valuation for Pepsi, I can't make the numbers work for me to consider adding this into my portfolio.

So, it's definitely an interesting case study, a stock to have on your watch list and watch closely with what develops over the next few quarters. But, to be honest, I do think my assessment over the last few years has been right.

We've seen Pepsi decline and continue to trade in this low range relative to what they were trading at back in 2023 when they were close to $200 a share.