Consumer goods giants Unilever (LSE: ULVR), Diageo (LSE: DGE) and British American Tobacco (LSE: BATS) remain firm FTSE 100 favourites for investors.
However, the strength of demand for these three companies in recent years has been such that some analysts are now saying the shares have become overvalued and should be sold.
Overvalued?
Unilever, Diageo and BAT have certainly become more expensive. The table below shows how their price-to-earnings (P/E) ratios have soared over the last four years, and the extent to which their share-price gains have been driven more by the willingness of investors to buy at ever-higher valuations than by earnings growth.
| Company | P/E four years ago | P/E today | Share price four years ago | Share price today | Share price increase | Share price increase attributable to P/E change | Share price increase attributable to earnings change |
| Unilever | 17.1x | 23.9x | 2,013p | 3,198p | 58.9% | 45.3% | 13.6% |
| Diageo | 16.6x | 21.5x | 1,517p | 1,861p | 22.7% | 28.1% | (5.4%) |
| BAT | 15.6x | 20.2x | 3,030p | 4,206p | 38.8% | 31.7% | 7.1% |
As you can see, earnings have contributed relatively little to pushing these three firms’ shares higher. Indeed, in the case of Diageo, earnings are actually lower today than four years ago, which means the rise in the company’s shares is entirely down to investors being prepared to pay more for less.
Four years ago, the P/E ration of each company was broadly in the region of the FTSE 100 long-term historical average of 16. Today, we’re looking at heady ratings in excess of 20.
Time to sell?
The P/E ratio simply can’t go on increasing indefinitely and while there’s perhaps some scope for the current valuations to riser further still (fellow consumer goods firm Reckitt Benckiser is on a P/E of 26.8, for example), earnings growth will surely have to be the main component driving the share prices of Unilever, Diageo and BAT from here on.
So, with the afterburner of the rising P/E appearing set to fade, is it time to sell these three stocks?
I believe shareholders would be unwise to sell. Indeed, I reckon Unilever, Diageo and BAT are still worth buying at current levels.
Why to buy
Yields on cash and bonds continue to be so meagre that many investors are more or less being forced into looking to equities for anything like a decent return. And defensive stocks with reliable cash flows and relatively safe dividends — of which Unilever, Diageo and BAT are prime examples — fit the bill perfectly. This demand should continue to underpin support for the foreseeable future.
Furthermore, in the current low-growth world, these three companies are expected to post near-term annual earnings increases in high-single-digits, or even double-digits, as cost benefits from organisational changes come through.
For example, Unilever has recently adopted so-called ‘zero-based budgeting’ (ZBB). While traditional budgeting is incremental, with a ‘baseline’ of the previous year’s spend, ZBB requires managers to justify every single expense from scratch each year. Using ZBB, Heinz-owners Warren Buffett and 3G Capital were able to increase the company’s profit margins from 18% to 27% in two years.
Finally, Unilever, Diageo and BAT have tremendous exposure to emerging markets, where a combination of long-term rising disposable incomes and an appetite for the best-known global brands should provide a tailwind for these three brand-powerhouses long into the future.