I’ve always admired the quality of the Diageo (LSE: DGE) (NYSE: DEO.US) business, but I haven’t ever been persuaded to invest in the firm, due to its high P/E ratio and below-average yield.
However, Diageo’s share price is down by almost 10% from its August peak of 2,152p, while its business continues to prosper. This combination has made me reconsider my decision not to invest, and take a closer look at this first-class booze maker.
Not so expensive
The first thing I noticed was that Diageo’s falling share price and strong earnings growth mean that its 2013/14 forecast P/E ratio has fallen to around 16.9. At the same time, Diageo’s prospective yield has risen to almost 2.8%.
That’s still pricey, but it’s not outrageous, given the FTSE 100 averages of 13.6 and 3.2%. Diageo’s track record of outperforming the FTSE 100 — it has a ten-year average trailing return of 13.5%, versus 7.9% for the FTSE, according to Morningstar — means that it is reasonable to expect to pay a moderate premium for the company’s shares.
High profits
Diageo’s portfolio of leading premium brands — such as Guinness, Johnnie Walker and Smirnoff — means that customers are willing to pay a little more for their favourite drink.
This translates into remarkably strong profit margins for Diageo, which has an operating margin of around 22%. Of course, paper profits are no good if they don’t translate to free cash flow, but Diageo scores well here, too: it generated free cash flow of £1.5bn last year, representing 44% of its operating profits.
Shareholder returns
Diageo’s underlying book value — the net ‘sell-off value’ of the business — has doubled from £3.5bn to £7.0bn since 2008, rising much faster than its net debt, which is only 32% higher than it was at that time.
The significance of this is that it shows how Diageo’s management has created genuine growth for shareholders, rather than simply pumping up the company using debt.
Diageo’s return on capital employed — a key measure of growth in invested capital — has remained steady at between 16 and 20% for at least the last six years, during which time the firm’s gearing has fallen from 188% to 118%.
Although gearing of 118% is still higher than I like to see, given Diageo’s track record of asset and earnings growth, I think it’s acceptable — making Diageo a tempting buy.