What Price Should You Pay For Diageo plc?

diageoSpirits giant Diageo (LSE: DGE) (NYSE: DEO.US) appears to be nearing the end of its long run of strong growth, raising questions about its current premium valuation. How much are Diageo shares really worth?

What’s happening?

Diageo’s share price fell by around 4% on Friday after the firm reported organic sales growth of just 0.3% during the first nine months of its current financial year. Sales fell by 9.4% in the Asia Pacific region and were broadly flat in Europe and Africa, leaving only North America and Latin America driving sales growth.

Diageo’s French peer, Rémy Cointreau SA, reported a similar fall in sales, due mainly to a slowdown in the Chinese market, where a crackdown on corruption has resulted in a dramatic fall in sales of expensive liquor.

I’d pay this much

Diageo currently trades on a forecast P/E of 18.3 and has a prospective yield of 2.7%. The FTSE 100 has a forecast P/E of 15.0 and a forecast yield of 3.2%, making it significantly cheaper than Diageo on both measures.

Diageo’s earnings per share have risen by an average of 11% per year since 2008, during which time the firm’s share price has gained 75%. This outperformance has previously justified the firm’s premium valuation, but I believe that Diageo’s slowing growth is a trend that has further to run: I expect to see mid-single digit percentage growth, at best, over the next few years.

In my view Diageo shares are still too expensive, but I’d be a buyer if the firm’s prospective yield rose far enough to match the forecast yield for the FTSE 100, which is currently 3.2%. Diageo’s 2014 dividend is currently expected to be 51.3p, so a fair price for Diageo shares would around 1,600p, in my opinion.

Although this target price is 14% below Diageo’s current share price, I don’t think that a pullback of 10-20% is unrealistic, given Diageo’s long-running outperformance.

Buy, sell or hold?

If you are an existing Diageo shareholder who purchased shares at a lower price, I don’t think there’s any reason to sell, unless you want to crystallise your capital gains — Diageo is still a great business.

However, new buyers should wait a little longer, in my view, as I’m confident there will be better buying opportunities over the next 6-12 months, as the full impact of Diageo’s slowing growth becomes more apparent.

A second opinion?

Of course, you may not agree with me. Many analysts rate Diageo as a strong buy at present, including the in-house experts at the Motley Fool, who recently selected Diageo as one of "The Fool's Five Shares To Retire On".

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Roland does not own shares in Diageo.