Why I'm still keeping Diageo on my radar; Sound investing often means taking no action – at least in the near term

It might seem odd to be spending time digging into the numbers of a company that I was less than enthusiastic about at first glance.

But as I'll explain today, when it comes to Diageo (DEO) – and other stocks like it – there's an important part of the investing process behind it...

In recent weeks, I've been analyzing the financials of five high-quality luxury businesses with strong global brands: Diageo, Constellation Brands (STZ), Brown-Forman (BF-B), and Paris-based companies LVMH (MC.PA) and Pernod Ricard (RI.PA).

On November 14, November 21, and November 22, I did a deep dive on LVMH... on Monday, I looked at Constellation's financials... and yesterday, I examined Brown-Forman.

Turning to Diageo, I took a quick look on November 13 – writing:

Britain-based Diageo owns a wide portfolio of well-known brands – including Johnnie Walker, Crown Royal, J&B, Buchanan's, Smirnoff, Cîroc, Ketel One, Captain Morgan, Baileys, Don Julio, Casamigos, Tanqueray, and Guinness.

After hitting an all-time high at the beginning of 2022, the stock has been nearly cut in half:

As I continued, the company's weaker revenue and earnings growth explain the less-than-stellar stock performance:

It's easy to see why Diageo's stock has only doubled in the past 20 years, as the company's revenue and earnings growth has been tepid:

Turning to valuation, as of yesterday's close Diageo has a $66 billion market cap and $21 billion of net debt – giving it an $87 billion [enterprise value "EV")]. The stock is trading at 4.4 times revenue, 12.7 times [earnings before interest, taxes, depreciation, and amortization ("EV")], and 16.5 times next year's estimated earnings per share.

I'm not excited about Diageo based on my quick analysis – it's a full valuation for a low-growth cash cow...

So, given my less-than-enthusiastic view of the stock a month ago (and the stock's small rise since), why should we spend more time looking into the financials now?

When it comes to these e-mails, shouldn't I only write about stocks I'm super enthusiastic about?

The short answer is no.

To be a successful investor, you need to be a learning machine and always look to expand the number of companies and industries you're familiar with. By doing so, you're giving yourself a base of knowledge so you can be ready to act – sometimes quickly – when opportunities present themselves.

I've long believed – based on both experience and extensive academic research – that the best returns come from owning the stocks of high-quality businesses that compound at a healthy rate over an extended period.

Of course, the problem is that every other investor (and supercomputer) loves these stocks... And therefore, most of the time, their valuations fully (if not over-) reflect the bright future prospects of these businesses.

But "most" doesn't mean "always"...

There are very few stocks, even of the greatest business, that don't get crazy cheap at times – sometimes only once a decade.

But if you wait to start doing your research only after a company encounters difficulties and the stock has gotten whacked, you might be too late.

Other investors who took the time to become familiar with a company and build up a long-term base of knowledge will pass you by, making better judgments about whether the beaten-down stock of a once-mighty company is a value trap – think Boeing (BA) or Intel (INTC) over the past decade – or a screaming buy – like Meta Platforms (META) and Netflix (NFLX) in late 2022.

So with that as background, it's well worth digging deeper into Diageo because it has powerful global brands (I listed some of them above) – which translates into mouth-watering margins and returns on equity:

Turning to the cash-flow statement, Diageo is an incredible cash cow...

As you can see in this next chart of cash from operations, capital expenditures ("capex"), and free cash flow ("FCF"), the company generates huge amounts of FCF (even during the global financial crisis and the pandemic) – but there has been no growth for two decades:

Looking at the balance sheet, Diageo has about $21 billion of net debt – up a bit in the past couple of years, but nothing to worry about:

I'm always curious to see how cash-cow businesses allocate their FCF because this can create (or, often, destroy) a large amount of shareholder value over time.

In Diageo's case, we can see a consistent dividend (the stock currently yields about 3.2%)... lots of mostly small acquisitions... and erratic and misguided share repurchases (ideally you want to see repurchases at low prices, but Diageo's largest repurchases were in 2019 and 2022 when the stock was near its highs):

I'll briefly touch on those repurchases... The ones we can see in the chart above from 2005 to 2008 and again since 2018 have moved the needle somewhat. They have reduced the share count by 25% over the past two decades – a little more than 1% per year.

Overall, after reviewing all these financials, Diageo reminds me a lot of Brown-Forman – so much so that I'll repeat part of what I wrote yesterday:

[This] looks like a classic high-quality cash-cow business. But it has shown little growth... its capital allocation has been uninspiring... and I'm not seeing any new line of business or big trend that's likely to change this.

In particular, given the explosion of wealth across the globe among the elite, other luxury-goods businesses – such as LVMH – that serve high-end customers have been able to grow their top line and margins substantially over the past couple decades... meaning their profits have soared. So I was surprised and disappointed that Brown-Forman [and in this case, Diageo] hasn't done the same.

With the caveat that I haven't met management, the financials tell me that this is likely an undermanaged business.

Turning to valuation, Diageo's stock has risen a bit since I last wrote about it a month ago. When I shared that first quick overview, the stock had closed at $119.68 per share the day before. Yesterday, it closed at $128.54 per share... up about 7%.

As of yesterday's close, Diageo now has a roughly $73 billion market cap and about $21 billion of net debt, which gives it an EV of around $94 billion (so it's a much larger business than Brown-Forman).

The stock is trading at about 4.8 times revenue, 13.7 times EBITDA, and 18.9 times 2025 estimated earnings per share – all multiples modestly lower than Brown-Forman.

But they're not low enough to interest me...

As I wrote about Brown-Forman yesterday:

My instinct and experience tell me that fair value for a stock like this might be 18 to 20 times current-year earnings, meaning I would only be interested in buying it at, say, 13 to 15 times earnings. (Normally I look for 50-cent dollars, but I would pay closer to intrinsic value for a high-quality business and low-risk stock.)

So I'll keep an eye on Brown-Forman [and now in this case, Diageo] and hope the stock gets whacked by a bad quarter or two... At that point, the valuation might get low enough where it looks like a good buy.

It might not be compelling enough now... but it's worth keeping on the radar.

I'm not disappointed by this conclusion. I certainly don't feel like I've wasted my time – or yours.

Sound investing (as opposed to speculating) is a process that requires a lot of work that 99% of the time results in no action whatsoever – at least in the near term.

But together, we've added another high-quality company to our watch list. And if we keep doing this once or twice a week, month after month, year after year, we will be well rewarded – I can promise you that, based on a quarter-century of experience.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.