Does Diageo plc Pass My Triple Yield Test?

Claive Vidiz whisky collection

Like most private investors, I drip-feed money from my earnings into my investment account each month. To stay fully invested, I need to make regular purchases, regardless of the market’s latest gyrations.

However, the FTSE’s gains mean that the wider market is no longer cheap, and it’s getting harder to find shares that meet my criteria for affordability.

In this article, I’m going to run my investing eye over Diageo (LSE: DGE) (NYSE: DEO.US), ahead of its interim results on 30 January.

The triple yield test

Today’s low cash saving and government bond rates mean that shares have become some of the most attractive income-bearing investments available.

To gauge the affordability of a share for my income portfolio, I like to look at three key yield figures –the dividend, earnings and free cash flow yields. I call this my triple yield test:

Diageo Value
Current share price 1,937p
Dividend yield 2.4%
Earnings yield 5.1%
Free cash flow yield 1.6%
FTSE 100 average dividend yield 2.9%
FTSE 100 earnings yield 5.9%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.8%

A share’s earnings yield is simply the inverse of its P/E ratio, and makes it easier to compare a company’s earnings with its dividend yield.

Diageo’s earnings yield of 5.1% is slightly below the FTSE average, reflecting the firm’s premium valuation — Diageo shares trade at 19.6 times last year’s earnings. However, Diageo’s track record of growth suggests that this rating can be justified, and 2014 earnings forecasts place the shares on a P/E rating of 18.0.

Although Diageo’s 2.4% yield is below the FTSE average of 2.9%, the drinks firm’s dividend has grown at an average rate of 6.7% since 2008, and has grown every year since at least 1998. In my view, this makes a lower initial yield acceptable, as in the long run, reliable dividend growth is critical to the success of an income portfolio.

For me, the only fly in the ointment is Diageo’s low free cash flow yield of 1.6%. However, this reflects acquisitions made last year, rather than poor cash generation, and given Diageo’s record of successfully integrating acquisitions, I can accept this.

Is Diageo a buy?

Diageo’s share price is down by 10% from the all-time peak of 2,152p it reached last summer, and I believe the firm’s shares are a buy.

Although I expect Diageo’s growth to slow slightly the next few years, it should remain highly cash-generative. Furthermore, any slowdown in the rate of acquisitions should mean that more cash can be returned to shareholders and used to pay down the company’s above-average level of debt.

A share to retire on?

"Diageo's strong brand portfolio and growing presence in rapidly growing emerging markets should provide it with the ability to keep growing cash flow - and its dividend - for years to come."

Not my words, but those of the Fool analysts Nate Weisshaar and Nathan Parmelee, who recently selected Diageo for their exclusive report, "5 Shares To Retire On".

The five companies featured in this report currently offer an average dividend yield of more than 4% and could be ideal retirement shares. For instant access to your copy of this free report, simply click here now.

> Roland does not own shares in Diageo.