Can Diageo's (LSE: DGE) growth continue and are the shares cheap?
Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If bought when the shares are cheap, two drivers could move the share price up:
- growth in earnings, and
- an upwards P/E re-rating.
Highly successful fund manager Peter Lynch classified steady growers as Stalwarts, which he typically traded for 20% to 50% share-price gains. But whether buying for gains like that or holding for the longer term, we need to know if reliable earnings growth can continue, and whether the shares are cheap.
Seeking durable growth
Not all companies achieve stable growth as you can see by the aggregate performance of those in London's premier FTSE 100 index (UKX), where the compound annual earnings-growth rate has been just 0.7% over the last five years:
|Year to June||2007||2008||2009||2010||2011||2012|
|FTSE 100 index||6608||5626||4249||4917||5946||5571|
|Aggregate earnings per share||537||503||427||397||527||557|
Consistent, cash flow-backed growth in profits is a promising characteristic in today's markets so, for this series, I'm examining firms with annual earnings growth between 4% and 20%.
One contender is Diageo (LSE: DGE) (NYSE: DEO.US), which is an international brewer, distiller and drinks manufacturer. This table summarises the company's recent financial record:
|Year to June||2008||2009||2010||2011||2012|
|Adjusted earnings per share||64.4p||69.7p||72p||83.6p||94.2p|
So, earnings have grown at an equivalent 10% compound annual growth rate putting Diageo in the Stalwart category.
Employing some 20,000 people worldwide, Diageo describes itself as the world's leading premium drinks business and is responsible for well-known brands such as Johnnie Walker, Bushmills, Smirnoff, Baileys, Captain Morgan, and Guinness.
Underpinned by those seemingly steel-reinforced brands, the firm has been enjoying lively growth from emerging markets, which provide almost 40% of sales. Elsewhere, sales have also been growing, both organically and through acquisitions. Last year, around 34% of revenues came from Europe, 28% from North America, 15% from Asia Pacific, 13% from Africa, and 10% from Latin America and the Caribbean.
I reckon alcohol consumption is more addictive than many people realise, which leads to rock-solid repeat business for firms like Diageo, guardians of some of the word's best-loved drinks brands. Add to that base the impressive growth figures that the firm regularly posts and this stalwart's business seems set on an upwards trajectory. How about the shares? Well, that will depend on valuation as well as the underlying growth of the business. If investors can get their timing right, Diageo could be an interesting proposition.
Diageo's earnings growth and value score
I analyse five indicators to determine whether earnings growth can continue and if the shares offer good value:
1. Growth: revenue and earnings growing steadily but cash flow has been declining. 2/5
2. Level of debt: net gearing around 111% with borrowings about 2.4 times earnings. 3/5
3. Outlook and current trading: good recent trading and a positive outlook. 5/5
4. Enterprise value to free cash flow: at around 33 is well above historic growth rates. 1/5
5. Price to earnings: a trailing 19 and above historic growth rates. 2/5
Overall, I score Diageo 13 out of 25, which leads me to believe this stalwart can continue earnings growth that out-paces that of the wider FTSE 100. Compared to the FTSE's price to earnings ratio of around 11 and the firm's growth predictions, the shares seem to be pricing in expectations of future growth.
Although revenue and earnings have been growing steadily, cash flow has yet to catch up. That said, debt seems to be under control and the director's are confident of further forward growth. Investors haven't missed this up-beat assessment, which results in the valuation scores dragging the overall result.
Right now, forecast earnings growth is 9% for 2013, and the forward P/E ratio is around 18 with the shares at 1815p. Considering that and the other factors analysed in this article, I think that's a little strong for me, like the drinks, so Diageo can stay on my watch list for now.
Diageo is one of several steady-earnings-growing stalwarts on the London stock exchange, each with the potential to deliver significant capital appreciation when purchased at sensible prices.
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> Kevin does not own any shares mentioned in this article.