Diageo plc's (LON:DGE) Business Is Yet to Catch Up With Its Share Price

It's not a stretch to say that Diageo plc's (LON:DGE) price-to-earnings (or "P/E") ratio of 16.4x right now seems quite "middle-of-the-road" compared to the market in the United Kingdom, where the median P/E ratio is around 16x. However, investors might be overlooking a clear opportunity or potential setback if there is no rational basis for the P/E.

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While the market has experienced earnings growth lately, Diageo's earnings have gone into reverse gear, which is not great. One possibility is that the P/E is moderate because investors think this poor earnings performance will turn around. You'd really hope so, otherwise you're paying a relatively elevated price for a company with this sort of growth profile.

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Is There Some Growth For Diageo?

In order to justify its P/E ratio, Diageo would need to produce growth that's similar to the market.

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 7.9%. As a result, earnings from three years ago have also fallen 8.3% overall. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Looking ahead now, EPS is anticipated to climb by 5.3% each year during the coming three years according to the analysts following the company. Meanwhile, the rest of the market is forecast to expand by 16% per annum, which is noticeably more attractive.

With this information, we find it interesting that Diageo is trading at a fairly similar P/E to the market. Apparently many investors in the company are less bearish than analysts indicate and aren't willing to let go of their stock right now. Maintaining these prices will be difficult to achieve as this level of earnings growth is likely to weigh down the shares eventually.

The Bottom Line On Diageo's P/E

It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

We've established that Diageo currently trades on a higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the moderate P/E lower. Unless these conditions improve, it's challenging to accept these prices as being reasonable.

Plus, you should also learn about this 1 warning sign we've spotted with Diageo.

If these risks are making you reconsider your opinion on Diageo, explore our interactive list of high quality stocks to get an idea of what else is out there.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.