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Why Diageo Plc Isn’t Quite A Five-Star Share

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Share prices are unpredictable from day to day and week to week. But when you look at shares over a period of years, it becomes clear that high-quality businesses are able to separate themselves from the pack with more consistent returns.

Guinness, Johnnie Walker and Smirnoff are just a few of the top global brands Diageo (LSE: DGE) (NYSE: DEO.US) has relied on to deliver intoxicating results for shareholders.  

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Here are five traits indicative of high quality businesses and how Diageo scores on each metric.

Revenue growth

There are many ways for companies to earn returns for shareholders, but the easiest way is to simply grow turnover. For large, mature companies like Diageo, I like to see turnover growing by 5% a year or more. That’s a hurdle Diageo has had no problem clearing in the last few years, earning it a full star.

Return on invested capital

Return on invested capital tells you how much a company earns for each pound of assets and non-interest bearing liabilities in the business.

Good companies earn a return on invested capital significantly above their cost of capital, which for most mature businesses is between 8% and 12%. I estimate Diageo earned a return on invested capital of 14% last year and this metric has been improving in recent years. That’s good for half a star.

(To earn a full star, I like to see a return on capital consistently above 15%. In the consumer goods world, Unilever and Reckitt Benckiser are two companies that clear this hurdle.)

Manageable debt

Debt has a bad reputation with investors. But for companies with consistent cash flow debt can be preferable to equity, because it is cheaper and temporary. With more than a hundred million units sold annually Diageo regularly earns more than £2bn in operating cash flow. That’s more than enough to cover its maturing debt and earns Diageo another star.

Cash flow conversion

Net income and earnings per share are helpful accrual accounting measures of business performance, but cash is what businesses need to pay their bills. That’s why I like to see operating cash flow on par with reported net income.  Diageo’s operating cash flow is consistently higher than its net income earning it a star.

Total yield

Total yield combines the dividend yield, share repurchases and debt reduction into one metric highlighting the funds returned to shareholders in any one year. Studies show that companies with high total yields tend to outperform those with low or negative yields. With a 2.3% dividend yield and slightly lower debt than a year ago, Diageo has a healthy total yield of 3.8% and earns one more star.

Putting it all together

Diageo earned 4.5 out of 5 stars, which is indicative of a high-quality business that should earn consistent returns for shareholders. Perhaps more important  is that Diageo’s performance is generally improving.

The verdict

These are five metrics indicating a high performing company. To make the final investment decision requires evaluation of the company’s management, valuation and other industry-specific considerations such as competition. I believe quality of Diageo’s results makes evaluating these other factors is worthwhile.  What’s your take?

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> Nathan Parmelee is the lead advisor for Motley Fool Champion Shares PRO and a co-advisor for Share Advisor. Nathan does not own shares of any of the companies mentioned.

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