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Why Diageo plc Looks Overvalued To Me At Present Levels

With its portfolio of billion-dollar drinks brands, Diageo (LSE: DGE) (NYSE: DEO.US) is a defensive company.

However, while the company would make a great addition to any portfolio, at present levels — and based on current trends — the company appears to be overvalued. 

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Fashion trends

One third of Diageo’s sales come from the United States. The company’s largest brand by sales in the region is Smirnoff Vodka. Unfortunately, vodka is falling out of favour in the US.

Falling vodka sales have hurt Diageo and compounded the group’s troubles during the first quarter of this year. Diageo’s North American sales only increased by 0.9% year on year during the first quarter, well below estimates, which were calling for growth of 2%. 

But even though Diageo’s North American sales growth missed expectations, it was the only bright spot in the company’s first-quarter results release. Group net sales during the three months to March 31 fell 0.7%. Sales fell in every single one of the company’s markets bar Africa and the US. 

And it’s not just fashion trends that are holding back Diageo.

The group’s sales remain under pressure within China as sales of expensive cognac, baidu and whisky have fallen following the country’s anti-corruption drive. Further, a clampdown by the Indonesian government on sales of drinks with less than 5% alcohol volume hitting beer sales in the world’s fourth most populous country.

Subdued growth

All of these factors mean that Diageo’s sales growth will be subdued this year. Earnings per share are set to fall. 

Specifically, according to City figures Diageo’s sales will expand by 4.8% this year. Meanwhile, earnings per share will decline by 5%, following a decline of 7% last year. After two years of declines, Diageo’s earnings will have fallen back to the same level they were at four years ago. 

With this being the case, it looks as if Diageo is overvalued at present levels. If City estimates are to be believed, at the end of this year the company’s earnings will be 7% above the level reported for full-year 2011.

However, since the end of 2011 Diageo’s shares have gained 35%. Moreover, during the same period the company’s P/E ratio has increased from 15 to 21.

So all in all, Diageo is approximately 40% more expensive now than it was back in 2011, although the company has failed to achieve any growth over the period. 

What about a takeover?

Even though I believe that Diageo looks overvalued at present levels, I wouldn’t rule out a takeover. Rumours have circulated recently that 3G, an investment vehicle controlled by three Brazilian billionaires, has been eyeing up Diageo.

As the value of merger deals has recently surged to an all-time high, it seems as if there is a strong appetite for deals across the market. 3G might not make an offer for Diageo, but another suitor could be willing to fork out the cash.

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Rupert Hargreaves 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.