Should I Invest in Diageo?

LONDON -- To me, capital growth and dividend income are equally important. Together, they provide the total return from any share investment and, as you might expect, my aim is to invest in companies that can beat the total return delivered by the wider market.

To put that aim into perspective, the FTSE 100 has provided investors with a total return of around 3% per annum since January 2008.

Quality and value
If my investments are to outperform, I need to back companies that score well on several quality indicators, and buy at prices that offer decent value.

This series aims to identify appealing FTSE 100 investment opportunities, and today, I'm looking at Diageo  (LSE: DGE  ) (NYSE: DEO  ) , the owner of many well-known alcoholic drink brands.

With the shares at 1,968 pence, Diageo's market cap is 49,437 million pounds.

This table summarizes the firm's recent financial record:

Year to June

2008

2009

2010

2011

2012

Revenue (million pounds)

10,643

12,283

12,958

13,232

14,594

Net cash from operations (million pounds)

1,560

1,619

2,298

2,183

2,093

Adjusted earnings per share (pence)

64.4

69.7

72

83.6

94.2

Dividend per share (pence)

34.35

36.1

38.1

40.4

43.5

With names such as Johnnie Walker, Bushmills, Smirnoff, Baileys, and Captain Morgan, most Brits have heard of, and probably enjoyed, Diageo's brands. But, actually, the firm's biggest market is North America, which accounts for around 39% of operating profit. Sales growth there in the nine months ending March 31 came in at 6%. That's not bad, but the star-performing region is Latin America and the Caribbean, which saw turnover grow by a frothy-looking 14%.

Other areas of full-strength growth are Africa, Eastern Europe, and Turkey, posting a 9% sales increase, and the Asia pacific, with a 4% uplift. Taken together, those fast-growing emerging markets earn around 35% or so of Diageo's total profits, enough for investors to get tipsy on, given the growth rates.

The firm's only underperforming region is, as you've probably guessed, Western Europe, which actually saw sales slip by 4% over the nine-month period. But Europe is becoming increasingly less important to the company, as it only delivers around 26% of overall sales.

Investors have noticed such attributes, and the firm's valuation is more Merlot than Stout. But total returns could yet work out for investors in the long run if turnover in those fast-growing regions keeps bubbling up.

Diageo's total-return potential
Let's examine five indicators to help judge the quality of the company's total-return potential:

  1. Dividend cover: adjusted earnings covered last year's dividend just over twice. 4/5
  2. Borrowings: net debt is running around 2.7 times last year's operating profit. 3/5
  3. Growth: flat-looking cash flow sits behind growing revenue and earnings. 3/5
  4. Price to earnings: a forward 17 overstates yield and growth expectations. 2/5
  5. Outlook: good recent trading and an optimistic outlook. 4/5

Overall, I score Diageo 16 out of 25, which encourages me to believe the firm has potential to outpace the wider market's total return over time.

Foolish summary
Decent dividend cover and a positive outlook top the company's attraction list. Debt seems under control, and growth in earnings and revenue has been good, but I'd like to see cash flow catch up going forward. The valuation seems full. So, for the time being, I'm putting Diageo on my watch list.

That said Diageo is one of "5 Shares to Retire On," a new Motley Fool report prepared by our top analysts highlighting five shares with seemingly impregnable, moat-like financial characteristics. They are shares that deserve consideration for any investor aiming to build wealth in the long run. For a limited period, the report is free. To download your copy now, click here.

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