Why Diageo plc Should Be A Loser This Year

Claive Vidiz whisky collection

How are our top FTSE 100 companies likely to do in 2014? That’s a question I’m trying to answer, and in most cases I think the prospects are looking good — but some seem to me to be a bit overpriced right now. Drinks giant Diageo (LSE: DGE) (NYSE: DEO.US), priced at around the 1,990p mark, is one of them.

Here’s how the past five years went together with analysts’ forecasts for the next two:

Jun EPS Change P/E Dividend Change Yield Cover
2009 69.7p +8% 12.5 36.1p 4.1% 1.9x
2010 72.0p +3% 14.7 38.1p +5.5% 3.6% 1.9x
2011 83.6p +16% 15.2 40.4p +6.0% 3.2% 2.1x
2012 94.2p +13% 17.4 43.5p +7.7% 2.6% 2.2x
2013 104.4p +11% 18.0 47.4p +9.0% 2.5% 2.2x
2014* 107.2p +3% 18.2 50.9p +7.4% 2.6% 2.1x
2015* 117.5p +10% 16.6 55.6p +9.2% 2.9% 2.1x

* forecast

Share price rise

Diageo shares have nicely outperformed the FTSE over the past few years — in fact, we’re looking at better than doubling over five years while the FTSE 100 has managed less than 70%. But the price has flattened off in 2013, and there are good reasons.

Firstly, that strong performance has, of course, lifted the shares’ valuation and reduced the dividend yield. And to me, a forward price to earnings (P/E) ratio of more than 18 for a share with a forecast dividend yield of only 2.6% immediately makes me suck my teeth.

Diageo is more highly valued than the FTSE long-term average P/E of about 14 (although in the short term, we have an average P/E of 17 for 2014 on the cards), and that 2.6% yield is below the forecast average of 3.1%.

Better dividends?

Sure, with a dividend cover of around two times, there’s room to boost the dividend a little — but lifting it to yield an average 3.1% would drop the cover to 1.7 times, and I really wouldn’t want to see it fall much below that. But that would still leave its P/E of 18.2 looking a bit rich to me with such modest cover.

My Foolish colleague Harvey Jones recently lamented Diageo’s strategy change away from growth through acquisition, pointing out that the firm is moving more towards a focus on higher-margin premium brands.

But that brings to my mind another sector that is failing to find growth in a diminishing market and adopting the same premium-brand strategy — the tobacco companies, and they’re in trouble.

Now, Diageo’s alcoholic staples are nowhere near as noxious as the weed (says a non-smoking drinker) and I’m sure the world won’t turn away from fermented beverages any time soon. But I do agree with Harvey that Diageo could be heading towards becoming an ex-growth company — and that its valuation as an income investment is too high with those low dividend yields.

Too expensive right now

We do still have a 10% EPS growth predicted for the year to June 2015, so fears that Diageo may go ex-growth in the very short term are probably overblown — but I do see it as a real possibility over the slightly longer term.

As the new strategy takes effect, Diageo’s yields may well grow to exceed that FTSE average as acquisition costs recede, but I think the share price has yet to catch up with the likely transition. And I think that probably means a stagnating 2014.

Verdict: Diageo shareholders will need a stiff drink in 2014!

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> Alan doesn't own any shares in Diageo.