An uncertain economic outlook means high-quality stocks are in demand. Characteristics such as a solid balance sheet, clear competitive advantage and diverse geographic exposure equate to lower risks in the short-run. They also provide enhanced reward potential over the long run as the world economy likely recovers.
The problem, though, is high-quality stocks are generally expensive. FTSE100 alcoholic beverages company Diageo [LON:DGE], for example, trades on a forward price-to-earnings ratio of 21x. This is significantly higher than many FTSE350 stocks – some of which trade on single-digit ratings. However, the firm’s growth potential, sound finances and excellent market position mean it is worthy of a high market valuation.
Sound performance
The firm’s recent trading update showed that it is performing well in spite of an array of challenges that include a cost-of-living crisis and geopolitical uncertainty. As such, it remains on track to deliver its medium-term guidance of organic net sales growth of 5% to 7% and organic operating profit growth of 6% to 9%.
This follows a highly successful financial year to June 2022, during which the company was able to fully offset high inflation through price increases and productivity savings. In fact, its organic operating margin increased by 121 basis points at a time when many consumer-focused firms were struggling to even maintain profitability.
This bodes well for its performance over the coming years, with high levels of inflation likely to persist for some time. It also highlights the strong competitive position and high degree of customer loyalty enjoyed by the firm that elevates its defensive, and growth, credentials.
Growth opportunities
Diageo’s solid financial position provides scope to purchase undervalued assets that can enhance its long-term growth prospects. Its ratio of adjusted net debt to adjusted EBITDA (earnings before interest, tax, depreciation and amortisation) of 2.5x is at the lower end of its target range. Meanwhile, net interest costs were covered over 10x by operating profit in its latest full year.
This allowed it to purchase two new brands during the year to further enhance its premium focus in an era where consumers continue to favour more expensive products. Indeed, high-end brands now contribute 57% of the firm’s total sales and drove 71% of organic net sales growth in the full year. The company was also able to grow or maintain its off-trade market share in 85% of its end markets. This suggests it is in a strong position to capitalise on a long-term economic recovery.
Its focus on innovation also provides a catalyst for growth. In the 2022 financial year, for example, it launched several limited editions of its most famous brands. They provide scope for higher margins and improving levels of customer loyalty.
Diageo investment potential
Clearly, Diageo faces ongoing risks such as a slowing global economy, the impact of China’s zero-Covid policy and a cost-of-living crisis. However, it offers a potent mix of defensive and growth characteristics that mean its risk/reward ratio is highly attractive. As a result, it is extremely worthy of its premium stock market valuation.
