PepsiCo Shares Still A Worthwhile Defensive Play Despite High Valuation

PepsiCo (NASDAQ:PEP), the global beverage and snack food giant, has substantially outperformed the US equity market over the past 12 months, with a total return of 24.1% vs. 8.4% for the S&P 500. PEP is often consensus outlook using ratings and price targets from 22 analysts. The consensus rating is bullish and the consensus 12-month price target is 3.4% above the current share price.

Source: Investing.com

With a bullish consensus outlook, but expected 12-month total return of only 5.5% (averaging the price targets values from Investing.com and ETrade and adding the dividend), is PEP worth the risk?

Market-Implied Outlook for PEP/h2

I have calculated the market-implied outlooks for the 2.2-month period from now until June 17, 2022 and for the 9.3-month period from now until January 20, 2023, using prices of options that expire on these two dates.

The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Source: Author’s calculations using options quotes from E-Trade

The outlook for the next 2 months is generally symmetric, although the maximum probabilities are tilted to favor positive returns. The maximum probability corresponds to a price return of +1.9%. The expected volatility calculated from this distribution is 21% (annualized), which is low for an individual stock and very close to the result from my September analysis.

To make it easier to directly compare the probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Source: Author’s calculations using options quotes from E-Trade

This view clearly shows that the probabilities of positive returns are consistently higher than the probabilities of negative returns of the same magnitude, across a wide range of the most-probable outcomes (the solid blue line is above the dashed red line over the left ½ of the chart above). This is a bullish outlook for PEP to the middle of 2022.

Theoretically, the market-implied outlook should tend to have a negative bias because risk-averse investors overpay for downside protection (put options). While there is no way to measure if this effect is present, the potential for a negative bias reinforces the bullish view.

The market-implied outlook for the next 9.3 months, from now until Jan. 20, 2023, exhibits a closer match between the probabilities of positive and negative returns. Even so, the probabilities of positive returns tend to be slightly higher than the probabilities for positive returns of the same size. Especially considering the expected negative bias, this market-implied outlook is slightly bullish. The expected volatility calculated from this distribution is 21% (annualized).

Source: Author’s calculations using options quotes from E-Trade

The market-implied outlook for PEP is bullish to the middle of 2022 and slightly bullish to early 2023. The expected volatility is low, at 21%, and is the same for both of these periods.

Summary/h2

Pepsico has delivered on earnings expectations and provided investors with high returns over the past year, even as inflation has been rising. The shares have benefited as investors have favored defensive stocks.

Its P/E is over 30, which is a concern. The Wall Street consensus outlook continues to be bullish, although the expected upside is very limited. The consensus for expected total return over the next 12 months is 5.5%.

As a rule of thumb for a buy rating, I want to see an expected 12-month return that is at least half the expected annualized volatility (21%) and Pepsico fails to meet this criterion.

That said, low-beta stocks justify an allocation because of their risk mitigation properties, even when they may not look attractive on a standalone basis. The market-implied outlook for PEP is bullish to the middle of 2022 and slightly bullish to early 2023. Even with the stretched valuation and limited upside, I am maintaining my buy rating.