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Diageo plc Could Be Worth 2200p!

When it comes to a track record of profitability, alcoholic beverages company, Diageo (LSE: DGE) (NYSE: DEO.US), is tough to beat. That’s because over the last five years it has increased its bottom line at an average rate of 6.8% per annum which, when you consider how challenging the economic outlook has been for the global economy, is a very strong result.

Valuation

Such consistency regarding growth numbers is something that investors are all too willing to pay for. In other words, Diageo offers more stability and a clearer earnings profile than the majority of FTSE 100 stocks and, as a result, trades at a deserved premium to the wider index. For example, Diageo has a price to earnings (P/E) ratio of 18.9, which is considerably higher than the FTSE 100’s P/E ratio of around 15.9.

While such a premium may put off many investors, it still appears to offer good value on a relative basis when compared to a key sector peer. SABMiller (LSE: SAB) (NASDAQOTH: SBMRY.US) is of a similar size, scale, and operates in many of the same markets as Diageo. Certainly, it is focused on beer rather than spirits (as Diageo is), but its business model and reliance on key brands makes is a useful comparator.

And, when you consider that SABMiller trades on a P/E ratio of 22.9, it becomes clear that Diageo could be subject to an upward rerating over the medium term. In fact, if Diageo were to trade on the same P/E ratio as SABMiller it would equate to a share price of just over 2200p which, from its current price of 1830p, would equate to a gain of 20%.

Looking Ahead

Of course, Diageo has invested considerable time and capital in developing its stable of brands and, as a result, it enjoys considerable barriers to entry. This is a major reason for its consistency, stability and why it could be worth a rating of over 22 times earnings, with its brands set to deliver sustainable growth that it not as dependent upon the macroeconomic outlook as most of its index peers.

This should provide investors in the company with confidence in its medium to long term prospects and, with the outlook for the global economy continuing to be somewhat uncertain, this consistency should allow it to outperform the wider index moving forward. And, with its closest UK-listed peer trading at such a large premium, now could be a great time to buy Diageo ahead of realistic gains of 20% over the medium term.

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Peter Stephens 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.