Is FTSE 100 Stalwart Diageo Good Value?

LONDON -- Capital appreciation is surely the goal of many investors, and one method to achieve it is to buy companies with steady earnings growth. If the shares are bought when cheap, two drivers could move their price up: growth in earnings and an upward P/E rerating.

Highly successful fund manager Peter Lynch classified steady growers as "stalwarts," which he typically traded for 20% to 50% share price gains. But whether buying for gains like that or holding for the long term, we need to know whether reliable earnings growth can continue and whether the shares are cheap.

Seeking durable growth
Not all companies achieve stable growth, as you can see by the aggregate performance of those in London's premier FTSE 100 index, where the compound annual earnings-growth rate has been just 0.7% over the last five years:

Consistent, cash-flow-backed growth in profit is a promising characteristic in today's markets, so for this series I'm examining firms with annual earnings growth between 4% and 20%.

One contender is Diageo (LSE: DGE.L) (NYSE: DEO), which is an international brewer, distiller, and drinks manufacturer. This table summarizes the company's recent financial record:

Earnings have grown at an equivalent 10% compound annual growth rate. putting Diageo in the stalwart category.

Employing some 20,000 people worldwide, Diageo describes itself as the world's leading premium-drinks business and is responsible for well-known brands such as Johnnie Walker, Bushmills, Smirnoff, Baileys, Captain Morgan, and Guinness.

Underpinned by those seemingly steel-reinforced brands, the company has been enjoying lively growth from emerging markets, which provide almost 40% of sales. Elsewhere, sales have also been growing both organically and through acquisitions. Last year, about 34% of revenue came from Europe, 28% came from North America, 15% came from Asia-Pacific, 13% came from Africa, and 10% came from Latin America and the Caribbean.

I reckon alcohol consumption is more addictive than many people realize, which leads to rock-solid repeat business for firms like Diageo, guardians of some of the world's best-loved drinks brands. Add to that base the impressive growth figures the company regularly posts, and this stalwart's business seems set on an upward trajectory. And how about the shares? Well, that will depend on valuation, as well as the underlying growth of the business. If investors can get their timing right, Diageo could be an interesting proposition.

Diageo's earnings growth and value score
I analyze five indicators to determine whether earnings growth can continue and the shares offer good value:

1. Growth: Revenue and earnings are growing steadily, but cash flow has been declining. Score: 2/5
2. Level of debt: Net gearing is around 111% with borrowings of about 2.4 times earnings. Score: 3/5
3. Outlook and current trading: Good recent trading and a positive outlook. Score: 5/5
4. Enterprise value to free cash flow: At about 33, it's well above historic growth rates. Score: 1/5
5. Price to earnings: A trailing 19 and above historic growth rates. Score: 2/5

Overall, I score Diageo 13 out of 25, which leads me to believe this stalwart can continue earnings growth that outpaces that of the wider FTSE 100. Compared to the FTSE's price-to-earnings ratio of around 11 and the firm's growth predictions, the shares seem to be pricing in expectations of future growth.

Foolish Summary
Although revenue and earnings have been growing steadily, cash flow has yet to catch up. That said, debt seems to be under control, and the directors are confident of further growth. Investors haven't missed this upbeat assessment, which results in valuation scores that drag on the overall result.

Right now, forecast earnings growth is 9% for 2013, and the forward P/E ratio is around 18 with the shares at 1,815 pence. Considering that and the other factors analyzed in this article, I think that's a little strong for me, like the drinks, so Diageo can stay on my watchlist for now.

Diageo is one of stalwarts on the London Stock Exchange steadily growing earnings, each with the potential to deliver significant capital appreciation when purchased at sensible prices. If you, like me, are serious about capital gains, I recommend you now read "The One U.K. Share Warren Buffett Loves," which is a time-limited Motley Fool free report discussing the British stalwart that has recently attracted some of the American super-investor's billions. Click here to access the report while you still can.