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These 3 Reasons Explain Diageo plc’s High Valuation

I have regularly considered Diageo (LSE: DGE) (NYSE: DEO.US) as a prospective investment.

However, one thing that has held me back in the past is Diageo’s high valuation. In particular, Diageo is currently trading at a historic P/E of 19.2, above the UK market average of 14.

What’s more, Diageo’s earnings per share are only expected to expand by 5% during the next financial year. In comparison, for the last 10 years Diageo’s earnings have grown at an average rate of 10%.

So at first glance Diageo looks expensive but is it worth it? 

Defensive industry

Well, to start with, Diageo’s position within the drinks industry makes the company highly defensive. The company has numerous premium spirit brands within its drinks cabinet, the sales of which do not tend to be affected by the economic environment.

In addition, the global market for premium spirits is growing at a double-digit rate and taking market share. For example, premium Cognac brands now account for around half of Cognac sales, up from less than a quarter several years ago.

Cocktail consumption has also been growing rapidly around the world and within the UK fuelling demand for Diageo’s spirits in general.

Scotch

A cornerstone of Diageo’s drinks empire is the Johnnie Walker Scotch whisky brand, which encompasses both premium and lower cost products.

This putts the company in prime position to ride the growing global demand for Scotch whisky. Indeed, according to The Scotch Whisky Association, during 2012 the value of Scotch exports rose by 11% to almost £2bn.

However, the fastest-growing market is not China or Brazil but the US, where sales expanded 19%. Moreover, the US Scotch market is 15 times the size of the Chinese market, so there is plenty of room for growth.

Cash, cash, cash

Nonetheless, in business cash is king and no matter what the company sells, if it’s not generating cash then the company won’t survive.

Fortunately, Diageo doesn’t have a problem making money. In particular, the company has a 39% gross profit margin and for the financial year ending 30 June 2013 the company generated £1.5 billion in free cash flow.

Surprisingly, this indicates that 29% of Diageo’s net income is being converted to cash. In comparison, GlaxoSmithKline, well known for its impressive shareholder returns, converts about 35% of net income to cash.

Foolish summary

All in all, after looking at the company’s defensive position and cash generative nature, I feel that Diageo does deserve its high valuation.

Indeed, defensive, cash generative companies like Diageo usually command a premium over the wider market due to their stability and Diageo is no different. So maybe, Diageo could be worth a second look.

Diageo is well known for its dividend prowess. Indeed, during the last five years the company has increased its payout around 10% annually. What’s more, as the payout is covered more than twice by earnings, investors can rest safe in the knowledge their dividend payout won’t be cut.

However, Diageo's current yield of 2.4% is around half of that offered by The Motley Fool's top income share for 2013. This company currently offers a dividend yield of around 5%, twice that of Diageo. 

This share was chosen by The Motley Fool's top analysts and they have put their thoughts on the matter together in this free report.

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> Rupert does not own any share mentioned in this article. The Motley Fool has recommended shares in GlaxoSmithKline.