The Warren Buffett Bull Case For Diageo plc

Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

Today, I’m considering whether FTSE 100 drinks giant Diageo (LSE: DGE) (NYSE: DEO.US) is a wonderful company, and whether its shares are trading at a fair price.

A wonderful company?

Diageo was formed from the merger of Guinness and Grand Metropolitan in 1997. Some years before, Buffett’s Berkshire Hathaway company bought 31.2 million Guinness shares. This 1991 investment was a landmark purchase, as Buffett explained to Berkshire’s shareholders:

“Our Guinness holding represents Berkshire’s first significant investment in a company domiciled outside the United States. Guinness, however, earns its money in much the same fashion as Coca-Cola and Gillette, US-based companies that garner most of their profits from international operations. Indeed, in the sense of where they earn their profits — continent-by-continent — Coca-Cola and Guinness display strong similarities”.

Buffett lifted Berkshire’s stake in Guinness to 38.3 million shares during 1992, and at the end of 1993 the holding was valued at $271m.

In Berkshire’s 1994 letter to shareholders, Buffett increased the threshold value of the equity holdings he named to $300m from the previous $250m, and Guinness disappeared from the list. I haven’t been able to discover whether Buffett had, in any case, sold the Guinness shares that year, as some commentators at the time suggested; or whether the history of the holding continued under the radar beyond 1994.

What I can tell you is that five years later — and two years after Guinness and Grand Metropolitan merged to become Diageo — Buffett bought shares in Diageo’s rival Allied Domecq. Buffett held the Allied Domecq shares for less than two years, and turned a tasty profit.

So, we know that Cherry-Coke drinking Buffett isn’t averse to an investment tipple of hard liquor. Furthermore, he’s looked to the UK in the past for such investments.

Premium drinks brands have great margins and deliver the kind of high return on equity (ROE) Buffett loves. Diageo today has more valuable brands, and bigger and better margins and ROE than were enjoyed by Guinness and Allied Domecq. In short, I think there’s little doubt that Diageo has the key qualities of a Buffett wonderful company.

A fair price?

Buffett values businesses as if he was buying the whole company.

EV/EBIT (enterprise value divided by earnings before interest and tax) is a simple whole-company metric that Buffett uses for a quick take on valuation. EV — a company’s market capitalisation, plus net debt (or minus net cash) — is the price he would have to pay to buy the whole company debt-free. At a share price of 2,007p, Diageo is on an EV/EBIT of 16.

Neither my memory nor my records go back to Guinness’s valuation when Buffett bought during 1991, while Allied Domecq wasn’t a pure drinks business, so isn’t directly comparable.

I think Buffett’s old comparison of Guinness with Coca Cola holds good for Diageo. As Buffett continues to maintain his stake in Coca Cola on an EV/EBIT of over 16, Diageo might just be within fair value for a wonderful company.

Having said that, I note there have been some days when you could buy Diageo at under £18 during the last six months, at which level the case for fair value would be stronger.

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G A Chester does not own any shares mentioned in this article.