This P/E Suggests Diageo Is a Hold

LONDON -- The FTSE 100 has risen by 25% over the last year, and many top shares are beginning to look quite expensive. I'm on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I'm using a special version of the price-to-earnings ratio called the PE10, which is one of my favorite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last 10 years. This lets you see whether a company looks cheap compared to its long-term earnings.

Today, I'm going to take a look at the PE10 of drinks giant Diageo (LSE: DGE  ) (NYSE: DEO  ) .

Is Diageo a buy?
Diageo has been one of the great big-cap growth stories of the last 10 years. Since 2003, its share price has grown by 179%, and its dividend has increased by 69%, giving the firm an army of loyal shareholders.

However, I'm concerned that the company's share price might have got slightly ahead of its earnings growth. Does the firm's PE10 suggest underlying value, or is Diageo ripe for rerating?

 

Trailing
P/E

PE10

Diageo

18.9

34

Diageo's PE10 of 34 reflects the firm's strong growth, but I think Diageo is too large to be considered a pure growth play, and its trailing P/E of 18.9 looks quite expensive to me. Diageo's prospective yield of 2.5% is below the FTSE average of 3.3%, and its share price has fallen by 5.6% over the last three months -- nearly triple the 2% drop recorded by the FTSE 100 over the same period.

I think Diageo's share price may have peaked for now, and I expect that it may fall further this year, presenting an attractive buying opportunity. Although 18 of the 29 brokers polled by Reuters still rate Diageo as a buy, the firm's third-quarter update was quite downbeat. I reckon that this year's strong first-half growth is already factored into the price.

Hold Diageo
Diageo is an excellent company with market-leading products, high margins, and good long-term income prospects. However, it is expensive, especially when its net gearing of 122% is taken into account.

Diageo is on my own watch list, but I won't be buying any of its shares until they are more reasonably priced -- for now, I rate Diageo as a hold.

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