LONDON -- Successful investors use a disciplined approach to picking stocks, and checklists can be a great way to make sure you've covered all the bases.
In this series, I'm subjecting companies to scrutiny under five headings: prospects, performance, management, safety and valuation. How does Diageo (DGE 1.30%) (DEO 0.81%) measure up?
1. Prospects
Diageo is the world's largest seller of premium drinks, notably spirits but also beer, with a global market share of 27%.
While alcohol sales generally are resilient, the top end of the market is economically sensitive in developed markets. Emerging markets are experiencing rapid growth as recognized brands are taken up by growing populations with rising disposable incomes.
Diageo has established a global footprint through acquisitions of local brands. Its excellent distribution means it can introduce global brands into new markets and take new brands worldwide.
Its scale, buying power, and marketing spend gives it immense power with retailers, securing its economic moat.
2. Performance
Diageo has seen constant revenue growth since 2006. Margins have remained consistent and return on capital has remained solidly above 30%. That's delivered a superlative dividend track record.
Emerging markets are powering current growth. While total sales increased 10% over the past three years, emerging market sales increased by a third and now account for 40% of turnover.
3. Management
Leading Diageo since 2000, Paul Walsh is one of the FTSE 100's longest-serving CEOs. He crafted the group's focus on premium drinks and growth through acquisition.
Shareholders' main concern should be the rumors, always denied, that Walsh is preparing to leave. Ivan Menezes, the chief operating officer who has run several of Diageo's regional divisions, is a potential successor.
4. Safety
Net gearing is a high 135%, but much of the debt is in the form of long-term dollar-denominated bonds, and interest cover is a healthy seven times.
Diageo's 6.8 billion pounds of net assets are wiped out by 8.8 billion pounds of intangibles, but 6 billion pounds of the intangibles represents brands, so has monetary value. A 1 billion-pound pension fund deficit is the net of 7 billion pounds of liabilities and 6 billion pounds of assets, injecting some financial risk.
Cash flow is robust, with 3 billion pounds cash from operations covering 1.5 billion pounds tax, interest and non-discretionary capex, leaving 1.5 billion pounds free cash flow to cover 1 billion pounds dividends.
5. Valuation
Diageo is trading on a prospective price-to-earnings (P/E) ratio of 19 and yield of 2.4%. That's at the top of its historic P/E range, with the share price chased up by investors' appetite for defensive, dividend-paying stocks at a time of high uncertainty and low interest rates.
Conclusion
Diageo is expensive but its defensive markets, dominant competitive position, global footprint, and emerging market growth opportunities make it a highly attractive share to hold for the long term.
In fact, it's one of the stocks that The Motley Fool has picked as "Five Shares to Retire On," all companies that have dominant market positions, healthy balance sheets, and reliable cash flows. To find out which the other four are, you can download their report by clicking here -- it's free.
