These 3 Metrics Show Diageo plc Is Undervalued

Diageo  (LSE: DGE) (NYSE: DEO.US) could be one of the FTSE 100‘s most misunderstood and undervalued companies. The group is one of the world’s largest alcoholic beverage producers and owns many iconic brands such as, Guinness and Smirnoff Vodka. 

However, despite these world-class brands, Diageo still trades at a fairly average valuation of 18.2 times forward earnings. This valuation makes the company look cheap, in comparison to other FTSE 100 world leaders such as Unilever. 

Peers worth moreDiageo

As a world leading producer, it seems reasonable to suggest that Diageo should trade at a premium to its smaller peers, but this is not the case. For example, peers Brown-Forman, Pernod Ricard and Remy Cointreau, some of the world’s largest and most respected alcoholic beverage producers, trade at an average forward P/E of 25.9.

As covered above, Diageo currently trades at a forward P/E of 18.2. If Diageo’s valuation were to rise in line to that of its global peer group, then it is reasonable to assume that the company’s shares would be worth 2,600p each, 42% above current levels. 

And that’s not all, Diageo also appears undervalued on several other metrics. 

Free cash flow 

One way to place a value on Diageo is to value the company by using its free cash flow. The free cash flow to equity multiple is a measure of how much cash can be paid to the equity shareholders of the company, after deducting expenses such as capital investment and debt repayment. 

By calculating the company’s free cash flow to equity, and then applying a discount rate, analysts are able to place a value on the company’s shares. Using this method, analysts believe that Diageo could be worth around 2,200p per share. Using this method Diageo is currently undervalued by around 20%.

Sector valuation

Additionally, there’s Diageo takeover value to be considered. Specifically, Beam Inc, one of Diageo’s smaller peers, which produces the world famous Jim Beam Kentucky bourbon whiskey, was acquired by Japanese spirits giant, Suntory Holdings for $13.6bn in cash earlier this year. 

Now, $13.6bn is around 20 times Beam’s earnings before interest, taxes, depreciation and amortisation. Diageo currently trades at just under 13 times earnings before interest, taxes, depreciation and amortization. If a multiple of 20 times is placed on Diageo, the company’s market capitalisation should be £68bn, or 2,720p per share, 49% above current levels. 

Long-term nature

So, it’s clear that Diageo’s current share price is undervaluing the company on several financial metrics. What’s more, Diageo’s defensive nature means that the company is the perfect investment for you to tuck away in your retirement portfolio and forget about.

The best retirement portfolios need to contain more than one share and finding companies with similar defensive qualities to Diageo can be tough.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.