Diageo (LSE: DGE) shares have more than halved in value in recent years. As a result, they look cheap right now – currently the forward-looking price-to-earnings (P/E) ratio is just 14, falling to 13 using next financial year’s earnings forecast.
That latter multiple’s below the FTSE 100 average. And it begs the question: are the shares mispriced at current levels?
The bear case
To answer that question, we need to look at both the bear case and the bull case here. Starting with the bear case, Diageo’s facing challenges both in the short term and the long run.
In the short term, US tariffs are likely to hit profitability. These could cost the group up to $200m annually. Then, there’s debt on the balance sheet. As of the end of June, net debt was $21.9bn meaning that interest payments in the near term are going to be hefty.
Meanwhile, in the long term, the big issue is younger generations are drinking less booze due to the fact that they’re more health conscious (and socialising less). Another key long-term issue is GLP-1 weight-loss drugs like Wegovy. These can reduce cravings for alcohol.
Given these long-term issues, Diageo may not end up being the growth play many thought it would be a decade ago (when the company was aiming for 5%-7% top-line growth per year). Ultimately, the landscape appears to have changed.
The bull case
Looking at the bull case though, there are plenty of reasons to be optimistic here. For a start, Diageo has a portfolio of leading names. From Guinness to Tanqueray, it owns some of the biggest alcoholic beverage brands on the planet and many of these have significant value.
Next, it has substantial exposure to both North America and the emerging markets. These regions offer potential for growth, particularly the emerging markets, where wealth’s rising and consumers are aspirational in nature.
Additionally, alcohol has traditionally been quite recession-resistant. So while sales growth has slowed, sales are unlikely to suddenly fall off a cliff if economic conditions deteriorate.
The company’s also looking for a new CEO. If it made a strong appointment, the share price could bounce.
Finally, the group is focused on cutting costs right now. Recently, it upped its cost savings programme target to $625m from $500m.
My call
Weighing this all up, are the shares mispriced? I think so. I don’t think a P/E ratio of 13 is right for this stock, given its brands, recession-resistant nature, and exposure to the emerging markets. To my mind, a P/E ratio of 16-18 is more appropriate, despite the fact that the company’s clearly facing a few challenges today.
Given my view on the valuation, I think the stock’s worth considering today as a value play. A dividend yield of 4.3% adds weight to the investment case.
