Undervalued Dividend Growth Stock of the Week: Diageo PLC (DEO)

We’re starting a new year!

2015 is behind us, 2016 yet ahead.

I like to think of every single day as an opportunity.

As such, 2016 will present us 365 unique opportunities.

Opportunities to become healthier, wealthier, better versions of ourselves.

And one of the best ways to become a wealthier you, in my opinion, is to live below your means and plow your savings into high-quality dividend growth stocks at attractive valuations.

High-quality dividend growth stocks are stocks that actually pay you to to own them!

You’ll find more than 700 examples via David Fish’s Dividend Champions, Contenders, and Challengers list – an invaluable document that contains pertinent information on every US-listed stock with at least five consecutive years of dividend growth.

That’s right.

These stocks pay you dividends to own them.

If you buy stock in a company that pays a dividend, you’re getting paid cash money to be an investor.

What an incentive, right?

But it gets better…

These stocks also routinely and regularly increase their dividends, meaning you’re getting paid more and more over time to continue holding stock.

That’s irrespective of the stock’s price because dividends are funded via the underlying cash flow a business generates.

So that means dividends are the “proof in the pudding” – who wants to get told how profitable a company is when they can be shown? Moreover, you end up with more pudding year after year!

Now, I’m a big fan of buying and holding high-quality dividend growth stocks. You can see that yourself by checking out my real-money, real-life portfolio that should generate enough growing dividend income for me to live off of by the time I’m 40 years old (I’m 33 now).

But that doesn’t mean one should go out and buy any dividend growth stock at any time at any price.

You also want to make sure you’re paying less than fair value for stock, even one that’s high quality.

How does one go about determining whether or not they’re paying less than fair value?

Well, it pays dividends (see what I did there?) to learn how to value stocks.

Once you know how to value stocks, you’ll know whether or not the price a stock is being sold for is reasonable.

Stocks are just like any other merchandise in that they have a price tag attached but also an intrinsic value.

You wouldn’t just pay $500,000 for a mattress, right? Or $20 million for a pair of sunglasses?

I’m exaggerating, but for good reason.

You know better than to overpay by such a significant margin because you know a mattress and a pair of sunglasses aren’t worth such outlandish prices.

When it comes to valuing stocks, though, it’s a little less intuitive (buying stocks isn’t as common as buying mattresses or sunglasses) and a little bit more intricate.

The good news, though, is that there are a number of systems out there designed to help facilitate the process of valuing stocks. One such system, which is available right here on the site, was designed specifically for dividend growth stocks. Put together by fellow contributor Dave Van Knapp, perusing that valuation system makes the whole idea much more intuitive.

Once you’ve estimated what a stock is worth, you know what you should pay.

And what you should pay is as far below that estimate of fair value as possible.

That builds in a margin of safety, just in case your estimate is wrong or the company doesn’t perform as expected.

Now, I mentioned earlier that learning how to value stocks pays dividends.

Check this out: Price and yield are inversely correlated, all else equal.

Paying a lower price for a dividend growth stock means your yield is thus higher.

So assuming a dividend hasn’t been adversely affected by some type of problem with the business…

Buying in for a lower price means more dividend income and more dividend income growth.

Said another way, paying a lower price for stock means more money in your pocket. You’re automatically spending less money when you pay less.

But you’re also getting more income on an ongoing basis and more potential growth of that income (via dividend raises).

Like I said, it pays dividends to learn how to value stocks (and buy high-quality dividend growth stocks when they’re undervalued).

Fear not, though.

I’m going to save you a lot of work by uncovering a high-quality dividend growth stock on Mr. Fish’s list that also appears undervalued at this point in time.

Diageo PLC (DEO) is the world’s leading producer, distributor, and marketer of branded premium spirits. The company also owns select wine and beer brands in addition to a significant ownership stake in premium cognac and champagne producer Moet Hennessy, a subsidiary of French luxury goods company LVMH Moet Hennessy Louis Vuitton SE (LVMUY).

Let’s just take a look at some of the premium brands Diageo owns: Johnnie Walker, Smirnoff, Captain Morgan, Baileys, Tanqueray, Guinness, Crown Royal, Ciroc, Ketel One, and Don Julio.

This is one of those classic businesses. Truly a wonderful business model.

Alcoholic beverages have been around and popular for centuries now.

It’s a timeless product. One that people have been consuming, well, pretty much forever, and it’s highly likely that will continue on for decades or even centuries to come.

And premium brands command premium prices, which allows for excellent margins and plenty of profit.

Even better, a good chunk of that “profit-o-plenty” has trickled down to shareholders in the form of a growing dividend.

deoThe stock has paid increasing dividends to shareholders for the past six consecutive years.

The five-year dividend growth rate stands at 8.3%, which is really solid when considering the stock offers a yield of 3.13%.

That current yield of 3.11%, by the way, is about 30 basis points higher than the five-year average.

Meanwhile, with a payout ratio of 60.5%, the company still has a lot of flexibility in terms of future dividend raises.

A lot to like here with the dividend. You’re getting a pretty attractive yield that’s compounding at a very healthy rate. And the likelihood of Diageo increasing its dividend for years to come appears to be quite high.

Looking at the underlying operations and growth, however, tells us a lot more about the health of the business, its growth prospects, and the likely value of its stock.

We’ll take a look at the last 10 years’ top-line and bottom-line growth, which helps smooth out fluctuations due to larger economic cycles.

Now, Diageo is a business based in the UK. As such, they report their results in British pounds (GBP).

The company’s revenue is up from 7.263 billion pounds in fiscal year 2006 to 10.813 billion pounds in fiscal year 2015. That’s a compound annual growth rate of 4.52%.

Not terrible revenue growth but not excellent, either.

Profit growth has been similar, seeing earnings per share increase from 2.69 GBP to 3.80 GBP over this stretch, which is a CAGR of 3.91%.

Not particularly exciting but I think Diageo’s future is actually much brighter when looking out over the long haul.

Recent changes in the business including taking control of United Spirits (India’s largest spirits company and the second-largest spirits company in the world by volume), acquiring the other 50% (and full ownership) of Don Julio, restructuring of South African operations, and the sale of Chateau and Estate wine brands all bode well for Diageo, showing that management remains focused on execution and core competencies.

Furthermore, premium spirits sales can be affected by economic cycles. These are premium products, less recession-proof compared to low-end spirits and/or other alcoholic beverages. So Diageo remains sensitive to the broader global economy. And we can see that the Great Recession slowed the business down some.

But an improving economy could offer opportunities for consumers to trade up. In addition, Diageo estimates that over the next decade, one billion new consumers will be able to afford internationals spirits brands.

For perspective, S&P Capital IQ believes that Diageo will compound its EPS by an annual rate of 8% over the next three years, which is in line with the dividend growth rate over the last 5 years. Looking at the business model, the breadth, and strength of the brands, upper-single-digit growth appears to be viable.

If there’s one area of the business I’m not a huge fan of, it’s the debt load.

Although the balance sheet has been cleaned up over the last few years, Diageo still operates with a long-term debt/equity ratio of 1.02. And the interest coverage ratio is just over 6.

I’d prefer to see Diageo operate with less debt seeing as how this isn’t a particularly capital-intensive business model, but it’s moving in the right direction. This is the opposite of what one can see with a lot of other businesses that have gorged on cheap debt over the last few years, expanding balance sheets in the process.

Those concerns, meanwhile, are offset with fantastic profitability.

As one might expect, this is a very lucrative business. Over the last five years, Diageo averaged net margin of 21.45% and return on equity of 38.03%. Outstanding numbers both in absolute and relative terms.

This is a fairly low-risk investment here. There is some sensitivity to economic cycles, but these are products that by and large sell very well over long periods of time.

The company is well diversified across the world, with approximately 32% of net revenues generated in North America, 24% in Europe, 13% in Africa, 10% in Latin America and Caribbean, and 20% in Asia Pacific.

It’s estimated that Diageo controls 27% of global volume market share, which is substantially higher than the nearest competitor. The scale is a huge advantage, and likely to only become stronger after taking control of United Spirits.

In the end, this is a very profitable business that is focused on one of the oldest products the world knows.

But while the business is obviously very attractive, we also want to see an attractive valuation before considering buying shares.

The stock’s P/E ratio is sitting at 19.46. That’s lower than the broader market but more or less in line with the five-year average for the stock. However, the price-to-book ratio is notably below its five-year average, while the current yield is markedly higher than its five-year average. Not a steal, but I do think the stock is appealing right now. At the very least, it’s not expensive. And I’d actually argue a modest margin of safety exists.

What’s the stock worth? What’s a reasonable estimate of its intrinsic value?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That growth rate is below both the recent historical dividend growth rate as well as the forecast for EPS growth moving forward. It’s perhaps a bit aggressive with the slightly elevated payout ratio, I think the moves Diageo has been making lately puts it in a great spot in terms of additional capacity for returning capital to shareholders. The DDM analysis gives me a fair value of $121.77.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

So I think we’re looking at a very high-quality company that’s poised to do even better in the future, with its shares appearing to be moderately undervalued. A wonderful business available for a price below its likely intrinsic worth is an opportunity that should always be taken seriously. And I’m not the only one who believes this stock is undervalued right now.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates DEO as a 4-star stock, with a fair value estimate of $125.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates DEO as a 3-star “hold”, with a 12-month target price of $120.00.

You see a clear trend here where the prevailing belief is that this stock is worth somewhere around $120 per share. Averaging out the three estimates gives us a final valuation of $122.26. That would indicate the stock is potentially 12% undervalued right now.

deo scBottom line: Diageo PLC (DEO) owns some of the most well-known premium spirits brands in the world. These are products that practically sell themselves, leading to exceptional profitability. The company has been busy positioning itself for a brighter future, which bodes well. Meanwhile, the stock offers an appealing yield, solid dividend growth, and the possibility for 12% upside. This is an opportunity to buy stock in one of the best and most dominant businesses in the world at a price likely below what it’s worth.

— Jason Fieber, Dividend Mantra

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