The Diageo (LSE: DGE) share price has doubled since June 2012. Over the same period, the owner of brands such as Johnnie Walker, Tanqueray, and Baileys has paid dividends totalling 438p.
This means investors have seen a total return of nearly 130% over the last 7.5 years. And that doesn’t include the profits that would have come from reinvesting the drinks group’s dividends in additional shares.
Here, I want to crunch the numbers and see whether this outstanding performance is likely to continue.
Why the stock could double
There are two main reasons why a company’s share price might double. The simplest is if earnings per share double. In order for the stock’s valuation to remain unchanged, the share price would double as well.
What makes this picture more complicated is valuation. If a company’s shares are valued below the market average and its performance improves, then the share price might double, even if profits only rise modestly.
However, with Diageo the opposite applies. The company’s reliable growth and high profit margins mean it already enjoys a premium valuation.
The FTSE 100 as a whole is currently valued at 16.5 times earnings, with a dividend yield of 4.3%. By contrast, Diageo stock is valued at 23 times forecast earnings, with a dividend yield of 2.3%.
No sign of a slowdown
Diageo’s strong valuation isn’t necessarily a problem. The group has delivered average earnings growth of about 7% per year since 2014. Add in the dividend, and the average annual return has been close to 10%.
Recent years have seen the group invest in its operations to cut costs. The operating margin has risen from 28% in 2014 to 32% last year. This means profits have risen faster than sales, supporting strong share price growth.
Broker forecasts suggest the group’s earnings are likely to rise by about 7% in both 2020 and 2021. If the company delivers on these forecasts, I’d expect to see Diageo’s share price gradually move higher. Eventually, I’d expect the shares to double again — perhaps in another eight years.
What could go wrong?
US billionaire Warren Buffett’s first rule of investing is “never lose money”. There’s a good reason for this. A 50% loss requires a 100% gain just to break even. Avoiding such losses gives you a much better chance of beating the market.
As investors, I believe we need to consider what could go wrong when buying stocks. How safe is our money? I think Diageo’s long-term future looks pretty safe. I don’t think the world’s population is likely to become teetotal in my lifetime. However, I do think there’s a chance the group’s growth rate and valuation could weaken.
An economic slowdown in major markets such as China or North America could also hit sales and slow profit growth. And although Diageo’s profit margins have risen in recent years, this isn’t something that can continue indefinitely. When the group’s profit margins level out, earnings growth could slow.
My view
I think Diageo is a great company. The shares could double again — indeed, at some point I think they probably will. However, there’s already a lot of good news in the DGE share price. I suspect that, for patient investors, better buying opportunities could be available further down the line.
