Diageo’s update focuses on the efficiency savings it’s on course to achieve over the next three years. While it will mean upfront costs that will affect profitability in the short run, over a longer timescale, Diageo’s operating margins are set to expand. In fact, the company expects operating margins to increase by as much as 1% over the next three years.
Allied to operating margin improvements is huge growth potential. Diageo will focus on growing its top line performance in US spirits, in India and in Scotch whisky. The company has a bright future in all three areas and its geographic diversity provides a potent mix of reduced risk and high growth potential.
Across Asia, wages are increasing and this means that demand for alcoholic beverages is likely to rise. Should one part of the region or one region of the world disappoint however, Diageo has exposure across the globe that should be able to offset short-term challenges elsewhere.
Allied to this geographic diversity is product diversity. Diageo has premium brands across the stout, whisky, vodka and various other alcoholic beverage categories. This reduces the company’s risk profile and means that it’s deserving of a higher rating than a smaller, less diversified sector peer such as Fevertree.
While Fevertree has an impressive product stable that benefits from a high degree of customer loyalty, it lacks the size and scale of Diageo. Yet it trades on a much higher multiple than its sector peer, with Fevertree having a price-to-earnings (P/E) ratio of around 53 versus a P/E ratio of 21 for Diageo.
Certainly, Fevertree is forecast to grow its bottom line at a faster rate than its much bigger peer. For example, its net profit is due to increase by a massive 62% this year and by a further 11% next year. This compares with Diageo’s earnings growth outlook of a rise of 14% in the current year. However, when comparing the two companies on their price-to-earnings growth (PEG) ratios, Diageo has considerably more upside potential. That’s because its PEG ratio is 1.4, while Fevertree’s is high at 4.4.
In addition, Diageo has better income prospects than Fevertree. The former yields 2.9% from a dividend that’s well covered at 1.6 times. Meanwhile Fevertree’s high valuation means that its yield stands at only 0.5%, although it too is well covered by earnings at 3.9 times.
Clearly, both stocks are attractive based solely on their financial performance. But Diageo offers significantly better value for money as well as a lower risk profile. As such, it’s the better buy for the long term.
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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has recommended Diageo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.