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Here’s why the Diageo share price offers you a 5.3% return

Image source: Getty Images.

Today I’m looking for opportunities in the drinks sector. A consistent top performer in this market is spirits group Diageo (LSE: DGE), whose portfolio of brands includes Smirnoff, Johnnie Walker and Baileys.

This FTSE 100 group has benefited from two major trends in recent years. The first is increasing consumer spending power in many emerging markets, such as China.

A second trend that’s affected the drinks market is ‘premiumisation’ — customers are happy to pay more for better quality products with more exclusive branding. Diageo has used this opportunity to launch a number of new high-end spirits.

Make mine a double

Of course, as Foolish investors we don’t want to invest in trends alone. We should also be aiming to own shares in high quality businesses at attractive valuations.

In my view, Diageo’s recent results confirmed that its quality remains very high. If we ignore the impact of exchange rates, sales rose by 5% last year, while operating profit climbed 7.6%.

This performance resulted in an operating margin of 30.3%. That’s very high, but it’s in line with performance in previous years. This is a very profitable business.

A 5.3% ‘yield’ for shareholders

The quality of this business isn’t a serious concern, in my opinion. What is harder to judge is its valuation.

Diageo stock never really looks cheap. But even by the firm’s own standards, the current valuation looks quite steep to me. At the last-seen share price of 2,836p, the stock trades on a 2018/19 forecast P/E ratio of 22, with a dividend yield of just 2.5%.

The only thing that makes this price tag more palatable is the £2bn share buyback planned for this year. This cash is being returned to shareholders indirectly, by reducing share count and boosting earnings per share growth.

My calculations suggest that the buyback and dividend combined equate to a 5.3% shareholder return for the current year. Personally, this is a stock I’d prefer to buy on the dips. But I believe it remains a solid choice for long-term investors.

Will this growth stock leapfrog Diageo?

Diageo’s size means that growth is relatively slow. One smaller contender in this sector is Stock Spirits Group (LSE: STCK), which sells branded spirits in Central and Eastern Europe. As you might expect, the firm’s product range is dominated by vodka.

Today’s half-year results show that sales rose by 5.3% to €124.1m during the six months to 30 June. Operating profit rose by 9.7% to €18m, giving the group an operating margin of 14.5%.

A strong performance in Poland appears to have been tempered with a more mixed performance in the Czech Republic and Italy.

What does worry me

The company’s performance in recent years has been inconsistent. Annual sales have fallen from €340.5m in 2013 to just €274.6m last year. Profits have also varied widely.

Stock Spirits doesn’t seem to have been able to deliver the consistent growth that makes Diageo so attractive.

In fairness, this may be changing. The company said that today’s results were in line with expectations. Analysts expect further modest growth in 2019, and strong cash generation allowed the group to reduce net debt by €14.4m to just €38.7m during the half year.

At 212p, the shares trade on a forecast P/E of 13.7 with a prospective yield of 4.1%. If the group’s recent stability can be turned into sustainable growth, then these shares could be good value.

Buy-And-Hold Investing

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.