The Diageo (LSE:DGE) share price fell by 15% last week, reaching a 52-week low. While it’s rebounded a little, the stock is still trading where it was five years ago.
Opportunities to buy shares in a company of Diageo’s quality at a decent prices don’t come around often. So is the latest decline something investors should look to take advantage of?
Profit warning
The latest fall is due to Diageo’s management warning that the rate of revenue and profit growth is going to slow significantly. This is due to a weaker-than-expected performance in Latin America and the Caribbean.
As a result, the company’s medium-term guidance is coming down. Instead of anticipating operating income to grow between 6% and 9% per year, the estimate is now 5%-7%.
Investors have typically been willing to pay a premium for Diageo shares in the past. But that’s only justifiable if its strengths results in better earnings, which is why the recent news has sent the stock falling.
After last week’s decline, it is now at a price-to-earnings (P/E) ratio of 17. While this might be lower than its average over the last five years, it’s worth noting this is still high by FTSE 100 standards.
The relatively high multiple introduces an element of risk. As the last week has demonstrated, if earnings deteriorate further, then the stock call still fall sharply from here.
For investors, the question is whether or not the risk is worth it. The stock is clearly better value than it was five years ago, but is it too cheap to ignore even with lower forward earnings guidance?
Future returns
Diageo generated £1.64 in earnings per share, which is a return of 5.6% at today’s prices. And the company is forecasting at least 5% earnings growth per year over the medium term.
That makes it look like a much better bet than a 10-year government bond, which currently has a yield of 4.7%. And unlike Diageo’s earnings, the bond’s return isn’t going to grow in the future.
Of course, the returns on a government bond are highly unlikely to fall over the next decade. But even if future earnings come in at the lower end of the current estimates, there’s still growth for shareholders.
If the company achieves the lower end of its estimate – 5% annual growth – its earnings per share should grow to £2.67 over the next 10 years. That would put the stock at a P/E of 11.
Even with higher interest rates, I doubt the stock is going to trade at that level for any length of time. So I think the Diageo share price will go up if the business performs as expected over the next decade.
A stock to buy?
Diageo’s P/E multiple remains above the average for the FTSE 100. But even if the firm’s earnings come in at the lower end of expectations, I think there are still good returns to be had.
That’s enough to get Diageo shares on my list of stocks to buy. I’m not expecting explosive growth from here, but I’ve been buying the stock while it’s down.
