The FTSE 100 has some terrific companies that I’d like to own in my investment portfolio. But overpaying for shares is a real risk – especially in a market like this one.
That’s why I’m avoiding Diageo (LSE:DGE) shares at the moment. I think that the underlying business is very attractive, but its shares are just too expensive for me right now.
The business
Diageo’s biggest asset is its brand portfolio. Warren Buffett talks about ‘share of mind’ as a measure of brand strength.
I think Diageo’s brands are clearly impressive by this metric. They include the leading scotch whisky (Johnnie Walker), the leading vodka (Smirnoff) and the leading gin (Gordon’s) by sales volume.
There’s a tangible benefit to having powerful brands, too. They allow the business to maintain high operating margins and provide protection against inflation.
Over the last decade, the company has consistently maintained operating margins above 25%. That’s similar to Coca-Cola and around double those of PepsiCo.
Strong brands also allow the company to use its assets more effectively. Diageo generates £4.4bn in operating income using just under £6bn in fixed assets.
That’s a return of around 75% on fixed assets, which is between Coca-Cola (116%) and Pepsi (46%). So I think that Diageo’s brands are comparable with the best.
Investment return
There’s no question in my mind that Diageo is a good business that I’d like to own part of. But I don’t think that right now is the time for me to buy the stock.
At the moment, inflation and the prospect of a recession have investors on edge. That’s causing them to pile into steady, predictable companies.
Over the last 12 months, the Diageo share price has risen, while others have fallen. As a result, I find other stocks more attractive at the moment.
Diageo has around £16.5bn in debt and £2.5bn in cash. It generates just under £3bn in free cash annually.
With a market cap of £88bn, that’s a return of 2.78%. The concern with that, for me, is that the company isn’t growing fast enough.
Over the past decade, Diageo’s earnings have grown at around 4%. If that continues, then the average annual return over the next 10 years will be around 3.3%
That doesn’t sound impressive to me. I’d rather put my money elsewhere at the moment.
Experian, for example, has a current free cash yield of 4.21%. Moreover, the credit assessment company is growing its earnings at a faster rate.
Equally, Diploma’s free cash yield is 3.94%, but it has been growing at around 10%. I’m expecting an annual return of around 5% from the underlying business there.
A stock to buy?
It’s clear to me that Diageo has terrific brands that make it an attractive investment proposition. It’s a stock I’d very much like to own.
At the moment, though, I think that the price is too high. Since I’m more optimistic on other UK stocks at the moment, I don’t see myself adding Diageo shares to my portfolio… for the time being.
