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At What Price Would Diageo plc Be A Bargain Buy?

DiageoPatience is one of the key attributes of a successful investor. The likes of US master Warren Buffett have been known to wait years for the right company at the right price.

Now, while buying stocks at a fair price will tend to pay off over the long term, we all love to bag a real bargain.

Today, I’m going to tell you the price I believe would put drinks giant Diageo (LSE: DGE) (NYSE: DEO.US) in the bargain basement.

Premium price

Diageo’s shares are currently trading at 1,860p, putting the company on a forward P/E of 18.5 — a hefty premium to the FTSE 100 long-term average of 14.

It’s often said that Diageo deserves a premium price. After all, the company is the world’s leading spirits group, whose portfolio of outstanding brands includes Johnnie Walker whisky, Smirnoff Vodka and Captain Morgan Rum.

Diageo’s fantastic operating margin of 30% — testament to the scale of the business and desirability of the brands — is superior to most other companies in the broad ‘consumer goods’ sector. Food and household cleaning group Unilever, for example, has a relatively humdrum operating margin of 15%.

Now, while I don’t disagree that Diageo’s qualities make it a top-notch company, I believe a P/E of 18.5 is a little too big a premium to pay. This rating is about in the middle of Diageo’s historical range.

Bargain price

I’ve suggested on more than one occasion in the past that Diageo is perhaps only fair value at a P/E of 18: this time last year I was writing that “there may be better opportunities to invest than at the current price of 2,025p”.

Now, despite the shares currently trading at 1,860p, the P/E is still in that 18 area. So, at what price would I consider Diageo to be in the bargain basement?

As I mentioned earlier, I do think Diageo merits a premium to the FTSE 100 long-term average P/E of 14. I would consider I’m getting myself a bargain if could buy on a P/E of 16, maybe even 17. As things currently stand, that would imply a share price of up to about 1,700p.

An alternative way of valuing Diageo that I’ve found has worked pretty well over the years as a decent bargain-buy signal is dividend yield. Specifically, looking for Diageo’s forward yield to at least match that of the FTSE 100 as a whole. Right now, Diageo’s shares would need to be trading at around 1,750p for the signal to flash.

My P/E and yield bargain indicators, then, aren’t too far away from each other: 1,700p and 1,750p, respectively. As such, I don’t see Diageo as being in the bargain basement just at the moment, but it’s not that far off; in fact, the shares have been as low as 1,709p as recently as last month.

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G A Chester has no position in any 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.