My Favorite Blue Chip Just Hit an All-Time High

LONDON -- A week ago, Diageo (NYS: DEO) -- the world's biggest distiller -- produced its third-quarter management statement. Once again, this didn't disappoint shareholders, with sales growing by 11% compared to the prior-year quarter and by 9% during the last nine months.

Soon after, Diageo's share price rose to an all-time high of almost 1,620 pence -- although, with the world's stock markets having thrown a wobbly since Friday afternoon, they have fallen back. As I type this, they are trading at 1,540 pence. (My editor says that I was tempting fate by mentioning the all-time high to him on the Friday morning!)

A very strong business
Diageo bucked the trend during the last recession; while most businesses were suffering, it continued to produce rising profits and dividends. This wasn't too much of a surprise, as alcohol sales will usually grow during an economic downturn, though many people will cut back by switching to cheaper drinks.

The statement showed the strength of Diageo's brands, with big increases in sales coming from Latin America and the Caribbean (18%), Africa (12%), and the Asia-Pacific region (10%). There was also some good growth in North America (5%), and this more than compensated for the 1% drop in sales within the eurozone.

As I wrote on Monday, Diageo is one of a group of companies that are already well-placed to increase their sales in the developing world, where an emerging middle class has a relatively large and growing disposable income and is eager to buy certain types of goods. These growth prospects are a major reason why Diageo is one of my largest core holdings and has been for many years.

Don't compare it with the FTSE 100
Many investors argue that Diageo's shares are overpriced because they are on a much higher price-to-earnings ratio than the FTSE 100 (INDEX: ^FTSE) index. I disagree, if only because around one-third of the FTSE 100 is made up of commodities producers such as the oil major Royal Dutch Shell and the miner Rio Tinto.

These companies are price takers with weak or nonexistent brands, so they have limited pricing power. Therefore, it is reasonable for their shares to trade at lower P/Es than those of companies like Diageo, which have a portfolio of world-class brands that gives them some pricing power even in today's markets.

If all other factors remain equal, a company with stronger brands will produce better results than those with weaker brands, and the market will thus value its shares more highly.

I'd also argue that the market prefers to compare Diageo with the other major international distillers, in particular Pernod Ricard, rather than with companies like Hammerson and Sainsbury, which don't do much business outside the U.K. and operate in completely different sectors of the economy.

The competition
I last looked at Pernod Ricard almost four months ago, when it was on a much higher P/E ratio than Diageo, as were the other big distillers such as Beam Inc. (NYS: BEAM) . Even after the last few months' gains, Diageo is still on a lower P/E ratio than these companies, though the gap has closed somewhat.

Furthermore, when you compare the distillers with the multinational brewers like Anheuser-Busch InBev (NYS: BUD) and SAB Miller -- whose products perform a similar function to Diageo's product range -- you'll see that they also trade on similarly high P/E ratios.

Show me the money
Diageo's shares at 1,540 pence are on a prospective P/E ratio of 16.9 where they yield 2.7%. I think they are reasonably priced at the current level, given Diageo's good prospects, its strong portfolio of brands, and the fact that distilling is a business that is highly resistant to technological change and is thus protected from competition to some extent.

But if I felt that the shares were somewhat overvalued, I still wouldn't sell, because I don't want to pay any more capital gains tax in the 2012-2013 tax year than I have to. If I sold, then something close to one-sixth of my sale proceeds would go in tax, so the share price would need to fall back to around 1,300 pence before I'd gain by selling and buying back.

Also, if I sold, I would no longer be receiving any dividends upon the money which would go to the taxman. That's something to think about, because the tax liability upon unrealized capital gains continues to earn you money until you crystallize it by selling.

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At the time thisarticle was published Tony owns shares in Beam, Diageo, and Sainsbury.Motley Fool newsletter serviceshave recommended buying shares of Beam and Diageo. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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