Diageo (LSE: DGE) (NYSE: DEO.US) is a company that many investors are put off because of its high valuation, with many investors saying that shares are too expensive at current levels.
However, I think that shares could still make gains because they are trading at a discount to the wider beverage sector. A narrowing of this discount could see Diageo’s share price increase relative to its sector.
For instance, Diageo currently trades on a price-to-earnings (P/E) ratio of 19.4. This seems high both on an absolute basis and also when compared to the FTSE 100, which trades on a P/E of 15.8.
However, when Diageo’s P/E is compared to the beverages sector (to which it belongs) it does not seem expensive, rather Diageo appears to offer relatively good value for money.
Indeed, the beverages sector currently trades on a P/E of 21.8, meaning Diageo’s shares are priced at a discount of 11% to the sector. The justification for this seems unclear, with Diageo seeming to offer at least as much fundamental quality, balance sheet strength and growth prospects as other listed beverage companies.
Furthermore, if Diageo were to trade on the same P/E as its sector, its shares would currently be price at around 2,275p. This would equate to a gain of 12% versus the current share price of 2,030p.
However, Diageo’s shares could be worth even more then 2,275p due to the attractive qualities that the company possesses. As well as being exposed to key growth markets across the developing world and having a strong portfolio of brands, Diageo is also fundamentally sound – as shown by the comfort with which it services its debt.
Indeed, the interest coverage ratio offers guidance on the mix of leverage and profitability that Diageo is currently experiencing, with it detailing how many times debt interest payments could have been paid by operating profit. Diageo’s ratio of 8.1 indicates that the company is highly profitable, since its debt levels are relatively high.
Taking this profitability into account means that Diageo could be worth a premium to its sector P/E, with shares having the potential to trade on a 10% premium to the P/Es of the likes of sector-peers Britvic and AG Barr. This would indicate upside of 23% and means that shares could be worth over 2500p each.