Its been a tough year for investors in Diageo (LSE: DGE), with the alcoholic drinks company seeing its share price fall by 9% since the turn of the year. That pretty much eradicates all of the 11% gains the company made during the course of 2013. In fact, since the start of 2013, Diageo has underperformed the FTSE 100 by around 16%. However, now could be a good time to buy shares in the company and they could rise by 17.5%. Heres why.
One of the major attractions of investing in Diageo is its highly resilient earnings profile. Indeed, Diageo seems to deliver impressive levels of profitability over the long run whether the global economy is performing well or not. Furthermore, its hugely diverse geographic spread ensures that even if one part of the world is experiencing economic difficulties, other parts have the potential to pick up the slack.
This bodes well for investors moving forward, since although Diageo does have a substantial exposure to Europe, strength elsewhere in the world should help the company to overcome slow growth in a number of its markets.
Although often viewed as a strong income play, Diageo seems to be rather mean when it comes to the proportion of profit that it pays out as a dividend. For example, its payout ratio currently stands at just 55%, which appears to be rather low. Certainly, the company needs to invest in new plant and machinery, but for a mature business operating in a mature industry, paying out just 55% of profit seems rather low.
Were Diageo to pay out a higher percentage of profit as a dividend, say 65%, then it could strike a more favourable balance between the reinvestment needs of the business and the income desires of shareholders. This could increase demand for shares and maintain the dividend yield at its current 3% level.
Assuming this is the case, it could mean that shares trade at a price of 2124p (as a result of a higher dividend still equating to a yield of 3%), which would mean a capital gain of 17.5% from its current price level. When the 3% yield is added to the capital gain, a 20%+ total return seems very achievable.
As a result of its capital gain potential, shares in Diageo could be well-worth buying. However, it’s not the only stock with a bright future. That’s why we’ve written a free and without obligation guide to where we think the smart money is headed.
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