Buying into a great company is one part of successful investing. But another is buying at the right price. I have long felt that Guinness brewer Diageo (LSE: DGE) is an excellent business. But are Diageo shares selling at the sort of price that would make me want to add them to my portfolio?
Why I like the business
First let’s start with what I think makes Diageo a great business.
It mainly focuses on making and selling alcoholic beverages, although it has recently also been growing its non-alcoholic offering.
It addresses a huge global market. Admittedly, one risk is fewer young consumers drinking alcohol. But that is why the expansion of Diageo’s non-alcoholic product lines looks like a savvy move.
But booze is also a crowded market. However, Diageo sets itself apart through owning premium brands with a unique identity, helping to build customer loyalty. That gives it pricing power, allowing the company to raise prices without necessarily losing sales.
Last year, sales of £22.4bn generated post-tax profits of £3.4bn. That is a net profit margin of around 15%, which I regard as attractive.
Shareholder returns
That sort of business can be highly cash generative. Diageo has raised its dividend annually for decades, with this year’s interim dividend up by 5% compared to the prior year.
Despite the company being a moneymaking machine, however, Diageo shares have fallen by 8% over the past year.
Yet on a five-year basis, they have risen by 21%.
Given that the dividend yield is 2.3%, that means that the annual percentage return on investment had I bought Diageo shares five years ago would have been in the mid-single-digits. That strikes me as decent — but not outstanding.
High valuation
The reason for that is simple — valuation.
Five years ago, Diageo was already widely seen as a superb business. Many investors wanted to own its shares back then, just as they do now. So the shares were not cheap. Do they offer good value now, after the price fall in the past year?
I do not think so. Currently, Diageo shares trade on a price-to-earnings (P/E) ratio of 22. That looks hefty to me.
Yes, a P/E ratio in the low 20s does not strike me as ludicrously expensive. I think I could buy today, hold for a decade and hopefully still turn a profit if Diageo continues to do well.
But the higher a P/E, the less error for margin I have as an investor. For example, if supply chain costs suddenly eat into Diageo’s profit margins, a high valuation could see the share price retreat.
Longer term, my returns on any share are based on what I pay for it in the first place. If I buy a mature company (as Diageo is) at a P/E of 22, I doubt I will be able to get outstanding returns from it. There are limits on business growth, but such a valuation already factors in high expectations of future value.
I would happily own the shares if I could buy them at a sufficiently attractive price. I do not think they sell for that today and have no plans to buy unless the price falls enough.
