Diageo is a low risk company with a long history of progressive dividend growth. But with a dividend yield of just 2.4%, are investors overpaying for its defensive characteristics?
The answer will depend on how quickly Diageo can grow its dividend, so the first thing I’ll do is try to estimate what sort of long-term dividend growth Diageo can realistically achieve.
Note: If you haven’t heard of Diageo before, it’s one of the world’s leading beverage companies and owner of brands such as Smirnoff, Bailey’s and Guinness. I wrote a very long review last year (perhaps too long) so have a look at that if you want more background information.
A history of inflation beating dividend growth
As investors we’re obviously interested in future performance and future dividend growth, and one of the best ways to find out what might happen in the future is to look at the past.
More specifically, I like to look at a company’s track record over at least the last ten years. Here’s a chart showing Diageo’s headline performance over that period:
As you can see, the dividend has grown progressively whilst being supported by both profit and revenue growth.
Here are the company’s growth figures in a bit more detail and compared to the FTSE 100 over the same period:
- 10-Year annualised revenue per share growth:
- Diageo: 2.5% / year
- FTSE 100: 5.4% / year
- 10-Year annualised earnings per share growth:
- Diageo: 6.4% / year
- FTSE 100: – 4.7% / year
- 10-Year annualised dividend per share growth:
- Diageo: 7.2% / year
- FTSE 100: 5.4% / year (estimated based on dividend growth)
A history of mediocre revenue growth
The good news is that Diageo’s dividend growth rate is a very healthy 7.2% per year, which is comfortably ahead of the FTSE 100’s also very healthy 5.4% dividend growth rate.
More good news is that Diageo’s earnings growth rate is also good at just over 6%, while the FTSE 100 has a negative 10-year growth rate (largely thanks to the volatile commodity prices increasing and then decreasing the earnings of large FTSE 100 companies such as Shell, BP and BHP Billiton).
The bad news is that Diageo’s revenue per share growth rate over the last ten years is quite weak at just 2.5% per year.
It’s especially bad news because revenues are the ultimate cap on growth and while dividends and earnings can grow faster than revenues for a few years, they cannot outpace revenue growth forever.
If Diageo’s overall growth rate over the next ten years is similar to its revenue growth rate over the last ten years then investors may be very disappointed.
The risk of a lower growth, higher yield future
Investors would be disappointed because a 2.4% dividend yield combined with a dividend growing as quickly as the historic revenue growth rate (2.5% per year) is only going to produce returns of 4.9% per year (i.e. 2.4% income plus 2.5% growth), assuming Diageo’s dividend yield stays the same.
That would be bad enough, but if that lower growth scenario came true then the dividend yield probably wouldn’t stay the same.
If the dividend was only growing at 2.5% per year (or thereabouts), investors would probably want a higher yield to offset some of that lower growth. They could quite reasonably demand a 5% dividend yield, which is more typical of mature, low growth companies.
So what would happen if that lower growth, higher yield scenario came true?
Well, today Diageo’s dividend is 65.3p. If the dividend grew by 2.5% per year for ten years then it would pay a dividend of 83.6p in 2028. If the dividend yield at that time was 5% then Diageo would have a share price of 1671p.
To put that into context, its share price today is 2700p, more than 1000p higher than the projected price a decade from now.
Under this scenario, the company would continue to grow steadily while investors grew steadily poorer, with a total capital loss of almost 40% over ten years.
Of course, this is all pure speculation and this gloomy low growth high yield scenario may never happen. Perhaps Diageo will somehow speed up its revenue growth rate so that it can continue to grow its dividend at 7% per year.
But perhaps it won’t, and that’s why I wouldn’t invest in Diageo at its current share price.
My target buy price
As a dividend-focused value investor I’m only going to invest in a company if the combination of its dividend yield today and potential dividend growth tomorrow appears attractive.
And for me, Diageo’s 2.4% dividend yield and potential dividend growth rate of somewhere between 2.5% and 7% are just not attractive enough.
But they’re not terrible either, and I think a small increase in its revenue growth rate and/or dividend yield might be enough to tip things in its favour.
What do I mean by small?
In terms of revenue growth, it would need to move towards 7% or so at the very least, and stay there for quite a few years. I’m not super-optimistic that this is going to happen.
In terms of the dividend yield, it would need to rise above 3% at the very least.
Going from a 2.4% yield to a 3% yield might not sound like much, but it’s a 20% increase in the income you receive, and most people would be very happy with a 20% pay rise.
By adjusting the underlying data in my stock screen, I can see that a share price of 2000p would give Diageo a dividend yield of 3.3%.
It would also move Diageo from 79th on the stock screen into the top 50, and I only invest in stocks from the top 50:
- Target buy price for Diageo: Below 2000p
To get below 2000p, Diageo’s share price would have to fall by more than 25% and nobody can know whether or not that’s going to happen.
However, I think it’s more likely that we’ll see a 25% price fall than an increase in revenue growth to around 7% per year.
And while some investors will say that Diageo could never decline by 25%, they probably said the same thing about Reckitt Benckiser in mid-2017, just before it fell 30% over the following year.
My target sell price
So I wouldn’t buy Diageo at its current price, but if I already owned it I wouldn’t sell it either.
With a rank on my stock screen of 79 it’s in the top half of the 200 companies I track on a daily basis, which means it isn’t cheap but it isn’t horribly expensive either.
If halfway up (or down) the stock screen is ‘fair value’, then Diageo is slightly better than fair value, despite its low yield.
As a general rule I’ll only buy companies that are in the screen’s top 50, and I start to think about selling when they drop out of the top 100.
For Diageo, that would occur if the share price went above 3000p. At that price it would also have a dividend yield of just 2.2%, and I’m not keen on holding stocks where the yield is close to or below 2%:
- Target sell price for Diageo: Above 3000p
So are investors overpaying for Diageo?
No, I don’t think so. But at its current price I find the investment case somewhat lukewarm.