Diageo shares aren’t worth considering unless this happens…

I recently heard a social media finfluencer suggest that Diageo (LSE:DGE) shares had reached a washout bottom. This term typically suggests that the stock may have bottomed out as the general downtrend of the shares caused low conviction shareholders to sell their positions too.

At a glance, a forward price-to-earnings (P/E) multiple of 13.4 times looks cheap for a consumer defensive giant of Diageo’s caliber. Investors accustomed to seeing this stock trade in the mid-20s over the last decade might be tempted to call a bottom.

However, I believe these figures are a classic example of how headline multiples can mask a more leveraged reality. When we incorporate the company’s $21.8bn net debt pile into the equation, the valuation becomes far less appealing.

A truer sense of value

By shifting our focus to enterprise value — which accounts for that significant net debt position — the true multiple jumps closer to 24 times. This isn’t just a technicality. It meaningly impacts business. It represents a substantial claim on future cash flows that must be serviced before shareholders see the benefit of a recovery.

And when we adjust the valuation for net cash, we see that Diageo is broadly trading in line with peers. The issue is that companies like AB InBev on are a more aggressive earnings growth trajectory over the next 24 months. By comparison, Diageo’s flat-lining forecast suggests that the ‘cheap’ entry point is more of a value trap than a value play.

The divestment case

As my colleague Stephen Wright suggests, the stock could benefit from a ‘shrink to greatness’ strategy. By divesting non-core assets like the African manufacturing and shares in a Chinese spirits enterprise, Diageo can raise significant cash to pay down debt or fund share buybacks.

And I get that. The company needs to become leaner and more profitable in order to appear like a more attractive prospect. Therefore, the path to a rerating likely hinges on the group’s ability to successfully slim down. The resulting company should have stronger margins and less debt.

It goes without saying that companies with stronger margins and less debt typically trade with higher valuation multiples. After all, Johnnie Walker, Smirnoff, and Guinness, to name a few, are household names and providing pricing power.

The bottom line

If these divestments are executed at favorable multiples, it could provide the necessary spark to shift market sentiment. Until then, I believe we need to play what’s in front of us. Because sales may not materialise. Or the company can’t achieve the prices it’s looking for.

And what’s in front of me doesn’t excite me. The dividend yield, which I haven’t mentioned before, at 4.5% — while attractive — is supported by a thinning coverage ratio that offers little margin for error. Coupled with the net debt position and slow growth, there’s no clear reason to add the stock to my portfolio.

So, for now, I don’t believe the stock is worth considering. However, I believe it’s worth watching closely in case the proposition changes.

The post Diageo shares aren’t worth considering unless this happens… appeared first on The Motley Fool UK.

More reading

• 3 FTSE 100 super shares I wish I’d bought 5 years ago!
• I’ve just doubled down on beaten-up Diageo shares – am I mad?
• The Diageo share price leaps after this insider buys big!
• How much passive income could a £20,000 Stocks and Shares ISA earn over 20 years?
• At an 11-year low, are Diageo shares the ultimate comeback play?

James Fox has no position in any of the shares mentioned. The Motley Fool UK has recommended Diageo Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

See author's posts