PEP is not a buy due to insufficient free cash flow coverage for dividends and shareholder returns; fundamentals remain weak despite recent earnings beat.

Amid PepsiCo's stock trading at its lowest level in 52 weeks, the company has just released its earnings results for the last quarter. Last year, the stock fell by 8%, and over the past five years it has fallen by 18 %.

Therefore, there is a lot we need to delve into regarding the updates surrounding this company. They have updated their forecast for 2026. Now, we have updated metrics of what their dividend situation looks like right now .

Now, let's take a quick look at the general background. As I said, the past five years have been extremely difficult. The stock had been trending downwards significantly over the past two years .

If you follow the channel, you know that the stock's performance has not been good.

Part of the problem is that the price-to-earnings ratio has declined significantly. The average 5-year price-to-earnings ratio is around 21. Keep in mind that if you look at 2022 and 2023, the stock was trading at around 25 times earnings.

Right now, they are trading at only 14.28 times.

Is this justifiable ? Is the decline in the valuation multiple justified? Well, that is determined primarily by one thing. Has the rate at which profits and free cash flows are growing slowed down ?

For example, let's start by looking at free cash flow by moving on to the dividend analysis sheet . Quickly, as always, if you want to download any of the spreadsheets to watch my videos and get stock data automatically in your spreadsheets, whether Excel or Google Sheets, you can check out Ticker Data via the link in the description.

You can get a free 7- day trial period. I'll talk about dividend payout metrics in a bit, but take a look at the free cash flow over the past five years. We have a 5-year compound annual growth rate (CAGR) of only 3.78% for free cash flow, and a 10-year CAGR that is effectively 0%.

Overall , free cash flow did not really rise to higher levels. It was very stagnant.

So, when you have a stock that is n't growing its earnings or free cash flow at all, the market usually decides that it's worth a lower valuation multiple. This is exactly what we saw in the case of Pepsi stock.

At the beginning of this year, when Pepsi released its forward guidance , they were forecasting revenue growth of between 2% and 4% for 2026. That's not very strong . This hardly keeps pace with the inflation rate.

Let's take a look at what happened in this latest earnings report. To begin with, we can note that we exceeded expectations in revenue by 5.6% as well as in net profit . Non-GAAP earnings per share for the third quarter were $2.34, exceeding expectations by 4 cents.

But here's the important thing we really need to focus on. If we go to the earnings report and start scrolling down, we will see the updated guidance they have given us. They expect net revenue guidance for fiscal year 2026 to be around 6%.

This falls within the upper limit of their previous guidelines. Overall, yes , this is a good sign, but there is something else we should point out.

Looking closely at organic revenues, they now expect around 3%, which is the average of their previous guidance range of 2% to 4% . So, yes, this is somewhat good news, but the stock still has a long way to go to get back on a growth trajectory. It is very important that they do exactly that.

Why is this the case? Well, that's because dividend indicators don't look good these days. Yes, this is a company that has historically grown its dividends spectacularly, with a current yield of 4.55%.

Just for comparison , look at the historical yield of this stock. It is much higher than what we saw in 2022 and 2023, when the yield was around 2.5% to 3%. Even if we look at the past decade, this is a higher return than what we saw during the 2020 crash.

So, this is very important. This is a much higher return than we are used to seeing.

The company continued to increase its dividend payouts even though its free cash flow was not growing. So, naturally, what does that mean? This means that dividend growth is unsustainable.

In other words, the dividend payout ratio from free cash flow is constantly increasing.

For example, in 2022, the stock generated free cash flow of approximately $5.6 billion, but they paid out $6.1 billion in dividends. This is not sustainable. That's a dividend payout ratio of about 110% of free cash flow, and now, over the past four years, we've been in a very dangerous range.

We can see that in 2023 it reached approximately 84.3% . This may be sustainable for a company like Pepsi, but we don't want it to get any higher, and that's exactly what happened.

The dividend payout ratio from free cash flow for 2024 was 100.5%. And in 2025 it reached 99.56%. The company uses all of its free cash flow to pay dividends,

and there's also a bigger issue here. This company is still buying back shares. Now, whether this was the right decision to allocate capital or not is one thing, but again, the company is slowly but steadily buying back its shares.

Now, why is this important? Well, it is important because we must remember that this is another form of returning capital to shareholders. The capital used in these share buybacks comes from free cash flow.

So, what we can see is that they expect to use around 8.9 billion of capital in 2026 as cash returns to shareholders. So, what does that mean? Well, that means cash dividends plus share buybacks.

8.9 billion, but we can see that the free cash flow in 2025 was only 7.6 billion . Therefore, unless free cash flow jumps to $8.9 billion in 2026, this will be another year in which their free cash flow does not cover total shareholder returns. Again, this is somewhat of a warning sign .

Now, why exactly does this happen ? What's going on with the stock? Okay, let's take a closer look at Pepsi's overall free cash flow metrics . If we come here and enter Pepsi's name , the data will be loaded thanks to TIKR's data, and one of the things I've seen people point out is that Pepsi's dividends are safer than you think because their capital spending is expected to decline, and that has been somewhat true.

You can see that capital spending has increased from 2015 to 2022, but we have actually been on a downward trend for capital spending overall over the past two years. At least we have seen a decline so far in 2025.

But again, free cash flow is not growing at a high enough rate, even if capital spending continues to rise somewhat in 2026, to justify the level of dividend payouts relative to free cash flow.

In fact, I just posted something on Platform X comparing Pepsi's operating cash flow, free cash flow, and dividend payouts so far in 2026 versus 2025. So, here's what we can see .

As of 2026, operating cash flow is approximately 7.95 billion. After deducting operating expenses, the free cash flow becomes approximately 5.86 billion. Dividends paid already stand at 5.94 billion.

Therefore, the free cash flow during the first three quarters still does not cover dividend payouts.

And remember those guidelines we just saw, they haven't changed: $8.9 billion in cash returned to shareholders, which also includes share buybacks. So, what's the problem here?

Well, much of this actually comes down to the free cash flow conversion ratio. Look right here. They are projecting a free cash flow conversion rate of approximately 80%.

Okay, let's go back to our free cash flow analysis sheet , and here we begin to uncover one of the big issues. Take a closer look at Pepsi. Again, keep in mind that we are looking for the free cash flow conversion ratio.

Now, what does this tell us ? Well, it tells us the percentage of profits that are actually converted into free cash flow. What we can see is that in 2025, this percentage was around 93.11%.

But they state that it will be around 80%, and perhaps slightly higher in 2026. But that is still a significant decrease. So , the overall quality of earnings doesn't look strong enough.

We have some potential problems with profit margins. Now, as we talk about operating margins, or margins in general, we can see that the operating margin has expanded by 195 basis points, which mainly reflects a net positive impact of acquisition and liquidation charges, credits, and the positive impact of market value gains on commodity derivatives.

So, yes, you can point out that some margins have expanded, but not necessarily for the core business model.

Not only that, but when they indicate that underlying operating profit has increased by 3%, keep in mind that this also includes a positive 4% impact from the customs duty refund.

To put that in context, that means approximately 178 million in customs duty refunds during the quarter.

So, was this a good earnings report for Pepsi? Well, compared to their previous instructions, it was indeed like that . But there is no doubt that Pepsi is still not a fundamentally strong stock.

They are facing some serious problems. Revenues are growing at only a slightly higher rate than inflation. They are facing some problems with their margins, and ultimately, they are still in a disastrous situation with regard to capital allocation.

Free cash flow doesn't actually cover dividends as yet in 2026. When you add the fact that they are still buying back shares, it constrains the overall shareholder payout ratio, which of course means less capital to reinvest, preventing further growth in the company at a time when the company is really struggling to increase revenue at a rate higher than inflation.

Everything I just mentioned is the reason why we continue to see the price-to-earnings (P/E) ratio falling. Therefore, the tendency is to think of Pepsi as a historically safe stock, but we have now seen that this is not necessarily true.

Even with the return on the stock approaching around 4.7 %. So, I don't want to sound too pessimistic. Overall, this is a good earnings report compared to expectations. However, the company still has a long way to go to enhance overall coverage for current dividend distributions and to fund future growth initiatives .

As an example to illustrate what I mean, let's turn to our stock valuation sheet and take a look at PepsiCo. Just look at Pepsi through the lens of its dividend discount model.

However, look at it through the lens of the reverse dividend discount model . With the stock currently trading at $128 per share, how much dividend growth is priced into the stock?

Okay, let's start messing around with the numbers. At 2%, we're not there yet . At 3%, we are not there yet . At 4%, we are very close to the current share price . Therefore, there is probably about 3.9% of permanent dividend growth priced in the stock.

Keep in mind that the dividend increase in May was around 4%, which is almost directly in line with what we see in this valuation model. Therefore, assuming they can maintain that, the stock is currently fairly valued even though shareholder returns over the past five years have been very weak.

It is also fair to point out that the yield curve has widened considerably, particularly in the last few months. But, for this year as a whole, look at the yield on 10-year Treasury bonds, which is now 5.23%.

A month ago it was at 4.8% and a year ago it was at 4.13%. There is no doubt for some investors that Pepsi's yield of around 4.7% should compete with the Treasury's yield of 5.23%.

This will undoubtedly affect this stock as well.

So , that's all. This is the update regarding Pepsi stock. It's not a stock I'd personally like to add to my portfolio, but for those who hold it, I hope this recovery plan actually starts to materialize.

The company still has a long way to go, but I think this earnings report was somewhat of a step in the right direction, even if it was a small one.