Diageo’s share price has increased by more than 300% since the financial crisis of 2009. In this article I argue that the share price is somewhat stretched and that expected returns are not particularly attractive. I also calculate a target price at which I would be happy to invest.
Diageo is a well known and generally much liked business. It develops and manufactures alcoholic drinks such as Smirnoff, Guinness and Johnnie Walker, which it then sells into more than 180 countries.
Diageo is a member of the FTSE 100 and has an enterprise value (i.e. the market value of shareholder equity plus debt) of around £87 billion, so it’s a very large and high profile company.
Emerging market expansion and developed market premiumisation
Diageo’s strategy for growth is to take advantage of two long-term trends:
- Emerging market expansion and
- premiumisation of alcoholic drinks in developed markets
Emerging market expansion: As emerging markets grow, their populations will usually have more disposable income. That income allows them to either a) buy alcoholic drinks they couldn’t previously afford, b) buy legal drinks rather than black market drinks and c) buy more expensive and “aspirational” international brands rather than cheaper local brands.
Diageo expects an additional 750 million consumers to be able to afford international brand spirits by 2030, which is a lot by any sensible definition.
Diageo tries to increase the amount and quality of alcohol drunk in these countries by offering a mix of both international and local brands at a variety of price points. The company’s long-term goal is to help these markets go through the same process of drink premiumisation as is currently occurring in developed markets.
Developed market premiumisation: In the US, many beer drinkers are upgrading to premium “craft” beers or switching to more expensive spirits. In Europe, spirits are replacing wine as the drink of choice. Both of these trends favour Diageo which has a broad range of highly profitable spirit brands.
In summary then, Diageo operates globally in defensive beverage markets which are expected to grow in terms of volume and/or profit margin for the foreseeable future. This is, of course, good news for shareholders as it’s likely to drive long-term revenue, earnings and dividend growth.
A long and consistent track record of growth
These growth trends have been in place for quite a while, and Diageo and its shareholders have long benefited from them.
Over the last ten years, Diageo has grown its:
- lease-adjusted capital employed (breweries, equipment, vehicles etc) by an average of 5.4% per year
- revenues by about 3% per year and
- earnings and dividends by about 7% per year.
As the chart above shows, the company has also produced very consistent growth.
Diageo’s growth appears to be sustainable
Diageo’s also appears to be producing sustainable growth, at least in terms of where the money comes from to fund it.
I say that because:
- Diageo produced average net returns (earnings after tax) on lease-adjusted capital employed (net ROLACE) of 13.4% over the last decade.
- Of that 13.4%, 7.5 percentage points were paid out as a dividend, leaving 5.9 percentage points to be reinvested within the company as equity capital.
- This means Diageo should be able to grow its capital employed by about 6% per year using retained earnings rather than additional debt or lease liabilities
- The company’s actual capital employed growth rate over the last decade was 5.4%, slightly below its 6% “self-fundable” growth rate.
This is yet more good news because it means that Diageo can probably continue to grow at its current mid-single digit rate without having to fund it with lots of excessive debt or lease obligations (unlike Ted Baker, which spent years growing too fast using other people’s money).
Consistent high profitability is a good indicator of competitive strength
As I just mentioned, Diageo has produced net returns on capital of 13.4% averaged over the last ten years. That’s comfortably above average (where average in the UK is high single digit) and also exceeds my profitability rule of thumb:
Profitability rule of thumb
Only invest in a company if its average net return on lease-adjusted capital employed over the last ten years is above 10%.
Just as importantly, Diageo’s net ROLACE was above 12% in every single year, so it was consistently highly profitable, year after year.
This is yet another good sign. Typically, high levels of profitability will attract competition, and in most cases greater competition leads to lower returns on capital. The exceptions to that rule are companies with strong competitive advantages, and my guess is that Diageo’s leading brands and scale are enduring competitive strengths.
To summarise then, Diageo seems to be a very good business, combining consistently high returns on capital with the ability to reinvest a material amount of those returns at similarly high rates of return, fuelling consistent sustainable dividend growth.
For many investors, this combination of quality and growth is the holy grail, but as a value investor I still think price is important, no matter how high the quality of the company.
Diageo’s impressive share price gains have left it with a relatively low dividend yield
Since the peak of the last bull market in 2007, Diageo’s share price has increased by about 180%. Over that same period, its dividend has increased by about 110%.
The fact that the dividend has growth more slowly than the share price inevitably means that the dividend yield on offer today is lower than it was a decade or so ago. More specifically, the dividend yield has gone from 3% in 2007 to 2.2% today.
This lower yield means that shareholders are either a) willing to accept lower returns than in the past, or b) expecting higher growth to offset the lower income.
I have no idea what returns other investors are expecting, but I’m still sticking with my long-term target of 10% annualised or more, on route to my long-term goal of growing my model (and personal) portfolio into a million pound portfolio.
Total returns come from the combination of dividend income and capital growth. With a total return target of 10% and a dividend yield of 2.2%, Diageo will need to grow that dividend by almost 8% per year, for at least the next decade or two, if its expected total returns are to exceed that 10% target.
Personally, I think that’s somewhat unlikely.
Diageo is unlikely to grow faster than it has in the past
As I mentioned earlier, over the last ten years Diageo has grown its per share revenues, earnings and dividends by 3%, 7% and 7% per year, respectively.
Over a similar period in the previous decade (adjusting for the early-2000s sale of Burger King and Pillsbury), Diageo’s revenues, earnings and dividends grew by 11%, 7% and 5% respectively.
The difference between these two periods is that in the earlier period revenue growth outpaced earnings and dividend growth, and in the later period earnings and dividend growth outpaced revenue growth. The first situation is sustainable while the second is not.
In other words, Diageo’s 7% earnings and dividend growth rate over the last decade have been driven by margin expansion, thanks to the premiumisation of alcoholic drinks in developed markets.
But profit margins can only be stretched so far.
In Diageo’s case, its margins have historically averaged about 20%, whereas its margins today are closer to 25%. That’s a significant improvement which has helped earnings and dividends grow at high single digit rates. But when margin expansion is no longer possible, earnings and dividend growth will have to slow down to the rate of revenue growth.
Unfortunately for Diageo, revenue growth has averaged about 3% per year over the last decade, and for a stock with a 2.2% dividend yield that’s a big problem.
If earnings and dividend growth slows to 3% over the next decade, the dividend yield plus dividend growth model (a simplistic but useful way of thinking about dividend growth stocks) says the expected return will be in the region of 5.2% (2.2% dividend yield plus 3% dividend growth).
The risk to shareholders is that not only will dividend growth be disappointing, but that the share price may fall as investors demand a higher yield to offset the lower dividend growth rate.
To some extent this slowdown of dividend growth is already happening, with Diageo’s dividend growth rate slowing down to 5% for the last four years.
I’m not saying that Diageo is a basket case, but the low dividend yield suggests that a lot of optimism is baked into the share price, and as Warren Buffett says, “you pay a very high price in the stock market for a cheery consensus”.
My target price for Diageo
With a dividend yield of 2.2% and a reasonable estimate of future dividend growth of say 5% to 6%, the yield plus growth model suggests that we should expect future returns from Diageo in the region of 7% to 8%.
This is below my target rate of return of 10%, which mean that Diageo’s current price of 3100p is too high for me (as I write the price has dropped to 2900p, probably because of the Corona Virus pandemic, but this doesn’t change my point about the price being optimistic).
If we say that Diageo can grow its dividend by 6% per year over the next decade or two, then the dividend growth model says I should demand a 4% yield on day one (technically it should be a yield of 4% from next year’s dividend rather than the current dividend, but as the difference is only usually a few percent I tend to ignore that technicality).
So my target price is the price at which Diageo has a yield of 4%, and that gives the following result:
- My target price for Diageo is 1,720p
That’s about 45% below today’s share price, so I don’t expect to see the shares at that level unless there is a serious shift in investor sentiment away from “bond proxies” and other “high quality” stocks.
But that’s fine by me, because there are plenty of above average companies out there which are not as popular or potentially overpriced as Diageo appears to be.
Diageo’s stock screen rank
At its current price of 3100p, Diageo is ranked 95th on my stock screen of about 200 FTSE All-Share consistent dividend payers.
95th isn’t terrible, but it’s a long way outside the top 50, which is where I tend to restrict my purchases to (and most purchases are inside the top 20).
At a price of 1700p, Diageo’s rank would improve from 95 to 35, leaving it squarely in the zone where I tend to look for new investments.
Having said that, Diageo is exactly the sort of company I like to invest in, so if the share price does become attractively valued at some point then I would be more than happy to allocate a few percent of my portfolio to this company.
You are ignoring the fact that Diageo has been buying back shares consistently over the last few years and will do so in the future as well so the share count is shrinking. The effective shareholder yield has actually been more than 4%.
I have held this for the last 10 years with more than double digit returns and from this point am confident it will be similar going forward as the business is in better shape and corona has beaten the price down.
John Kingham says
Hi Lemsip, I always look at per share results (revenues, earnings, etc) specifically so that buybacks or rights issues are taken into account. In Diageo’s case, its recent buybacks have only reduced outstanding shares by a few percent, so it doesn’t make a great deal of difference.
As for Diageo producing double digit returns over the next decade, I cannot share your confidence, although of course I could be wrong and the share price could continue to grow faster than the company.
I tend to value a stock on free cash flow yield and on that basis Diageo is still a hold for me and Terry Smith too it seems. Obviously he must be copying me 🙂
John Kingham says
I’m sure he is. I’ll probably review Diageo again in a year’s time so we’ll see how things are chugging along then.
Bill Walters says
This article is, as always from Mr. Kingham, well written and the conclusions sound. Diageo is exactly the type of company I like to own, and was in my portfolio for years.
Sadly, the experience was a mixed one. Yes, it’s up a lot. But as a US investor I compare DEO to the S&P500, and DEO has lagged quite a bit since 2014 once displayed in USD.
Perhaps much is due to the drop in the GBP after Brexit. But DEO is an international company and sells in all currencies, so I expected that this would drive larger profits and neutralize any currency concerns.
I certainly will consider buying DEO if it gets back to Mr. Kingham’s price range. Until then I’ll have to keep an eye on the company though the lens of consuming it’s products.
John Kingham says
Thanks Bill. Currency is an interesting point and can be a significant complicating factor in international companies.
Diageo’s revenues are generated from a broad spread of countries, with the US making up about a third and the rest spread reasonably evenly across the globe. So perhaps it’s sensible to look at GBP vs a basket of international currencies. Pound Sterling Live has a chart that might be useful for that:
Over the last ten years GBP is broadly flat against a basket of currencies, but over five years its down, so this has provided a tailwind in GBP terms for international companies reporting in GBP, like Diageo.
As you say, its weaker growth over the last few years would have been even weaker had it reported in USD, so from a US perspective Diageo may be even less attractive.
Rob M says
The US dollar has been very strong since 2011, up over a third against foreign currencies on a trade-weighted basis.
Clearly this depressed investment returns for US investors in non-US stocks (or US stocks with high amounts of non-US earnings).
At the same time it has given a significant boost to non-US investors (eg UK-based) with a large exposure to US stocks (this includes Terry Smith’s Fundsmith).
But at some point the dollar will turn, which is when non-US stocks (or any stocks with a large amount of non-dollar earnings) will shine again.
Eugen N says
For me free cashflow is all that matters. I have reduced my shares count in 2018 by about 50%, as I am not that keen on companies purchasing its own shares.
As per annual report, 2.3% increase in equivalent volume units, turnover increased by 5.8%, which means they can also put the prices up, as quality companies do!
Operating margin is 32%, increasing from 31.4%. Net earnings increased by 10%, not bad.
When people discount by 6% per annum quality companies, and you expect net earnings to increase above that, and you value a quality company selling something that people like (alcohol), I think that your DCF formulas produce a problem.
You should not mistake the investors 6% per annum they use to discount with my 15% expected return., or your 10% per annum!
In my opinion the company is slightly undervalued at this moment.
There is a whole bunch of investors who are investing in companies which have no barriers to entry., and discount those at 10% per annum!
Quality companies do something very unusual: they break the rule of mean reversion that states investment return must revert to the average as new capital is attracted to business activities earning super-normal returns.
They can do this because their most important assets are not physical assets, which can be replicated by anyone with access to capital, but intangible assets, which can be very difficult to replicate, no matter how much capital a competitor is willing to spend.
Moreover, it is hard for companies to replicate these intangible assets using borrowed funds, as banks tend to favour the (often illusory) comfort of tangible collateral for their loans. This means that the business does not suffer from economically irrational competitors, even when credit is freely available.
John Kingham says
Hi Eugen, apologies for the delayed reply.
I agree with most of what you’ve said, especially the bit about intangible and hard to replicate assets which help quality companies to attract or retain customers at very low cost, or to charge higher prices, and yet which cost little or nothing to maintain or grow.
Diageo has that in spades, so I do think it’s a “quality” business (I prefer the term “special”, but that’s just semantics).
My issue is just with the valuation, due to the yield plus “expected” growth calculation, on which we differ slightly.
As with all these reviews, they’re most interesting when revisited five or more years later to see how things panned out and how near to or far off the mark I was.
Hi John, I’ll eat my straw boater if Diageo ever gets to 17XX again.
Just looking in the cupboard to see if I can still lay my hands on it.
Not sure the valuation of Diageo works as you have laid it out, but time will tell.
Nick Train and Terry Smith are big holders, although I guess putting these guys on a pedestal is always dangerous.
Nick has has a poor performance on a number companies including Pearson, AG Barr, Man United, Rathbone Brothers, Fuller Smith and Turner, Greene King, etc. In spite of that, he has a lot of high profile winners as well.
Interesting point on Diageo and based on yout statement John and I’ll repeat it here :-
“”Diageo is a member of the FTSE 100 and has an enterprise value (i.e. the market value of shareholder equity plus debt) of around £87 billion, so it’s a very large and high profile company.””
If you look at Diageo’s share of the world spirits market, it has 2% of the market by volume and less than 4% by value.
So, casting aside the fact that it is considered a big company in the context of the FTSE100, it is a tiny company on a world scale. Its scope for growth is potentially enormous.
Also I guess if you look at the value of the business, retained earnings are as important, and probably more so than the dividend payout.
The company will have grown it’s pretax profit by 42% this year over the last 6 years, (and earnings by a greater amount) which is pretty impressive for such a large “tiny” world company. It also has a P/E at the lower end of it’s historical norm at around 19 looking forward at today’s price compared to 22-23+ historically.
The dividend yield is close to 2.8% into 2021 and the projected earnings growth is 7% into next year. It seems it is a glass half full or a glass half empty situation here.
I’d say Diageo will be at or above 25-32XX+ for a long time to come.
OK I’ve just found the straw boater – just in case.
John Kingham says
Hi LR, yes I also think Diageo is unlikely to fall to that target price, but that’s fine and I can just fish elsewhere.
As for its earnings growth rate, you’re right that it’s faster than dividend growth, but revenue growth has been low single digit for a long time so faster profit growth is coming from margin expansion, and that can only be taken so far.
Eventually it will have to speed up revenue growth to keep the dividend growing at high single digit rates. That may of course be possible, but I don’t see much evidence for it in recent years.
Eugen N says
John, some days you can grow your margin, some other times you can grow volume, other times revenue.
Diageo was good for a long time to do these, not all at once, but at least one of them.
This year it may be volume increase through an acquisition.
What I like about Diageo is that it achieves a 15% ROCE, and invests money wisely. The acquisition of Seedlip was a very smart one, non-alcoholic drinks grow at 25% from a low base!
Brendan Fallon says
Have you got your boater eaten Diageo hit the 17 mark on 19 March