This Stock Yields 8.5% and is a Magnificent Buy

Which stock has a massive dividend, solid growth outlook, and dirt-cheap valuation — all primed for strong investment returns moving forward? That would be British American Tobacco (BTI).

Admittedly, tobacco stocks aren’t for everyone, and it’s understandable if a company like this is an automatic no-go for your portfolio. But for those interested, the hated nature and the stigma of the tobacco sector have presented an arguably tremendous investment opportunity.

British American Tobacco is making strides in building its future business while offering one of Wall Street’s most enormous dividends. Factor in the stock’s share price, near 52-week lows, and you have a potential market-beater. Here is what you need to know.

Revenue and earnings growth is strong
Growth is the fundamental driver of all investment returns. Sure, a company can perform financial loop-de-loops for a while, but eventually, a business must grow to survive and thrive.

British American Tobacco is growing, despite the common knowledge that cigarettes are poisonous to one’s health and years of shrinking cigarette use. British American Tobacco’s combustible product volumes shrank by 5.2% in 2022, so that hasn’t changed.

But there is more to the company than that. Not only can British American Tobacco slowly raise its prices to offset volume declines, but management has leaned heavily into what it deems new categories, non-combustible products like electronic cigarettes, heat-not-burn devices, and oral nicotine pouches. Tobacco companies claim these products carry fewer health risks than cigarettes (though they’re still bad for you).

Management wants new category revenue to reach 5 billion pounds by 2025, up from 2.9 billion pounds in 2022. On a non-GAAP (adjusted) basis, companywide revenue grew by 7.7%, and earnings-per-share (EPS) grew by 13% year over year in 2022. These figures don’t factor in currency exchange rates, which can skew the reported numbers. Still, it signals that British American Tobacco is thriving. Even with currency fluctuations, it seems realistic to expect earnings growth between 4% and 8% in a given year.

The dividend sets a high floor
Part of what makes British American Tobacco such a compelling investment is that its dividend sets such a low bar to generate strong investment returns. ADR shares of British American Tobacco offer an 8.5% dividend yield at this writing. In other words, profits could grow by just 2% annually, and investors could still bag investment returns on par with the S&P 500‘s historical average returns.

Of course, an unsustainable dividend doesn’t do anyone much good, but investors need not worry. British American Tobacco generated 8 billion pounds in free cash flow in 2022, and its dividend costs roughly 5 billion pounds of that. That’s a dividend payout ratio of 62%, which is plenty healthy to support the dividend.

The company’s financial house is also in order; the company is leveraged at a very manageable 2.9X net debt (total debt minus cash)-to-earnings before interest, taxes, depreciation, and amortization (EBITDA).

Suppose the company did achieve mid-single-digit earnings growth. In that case, say 5% on average, the combination of that and its dividend sets investors up for 13% to 14% annual returns without needing anything extraordinary to happen.

A breathtaking valuation
There are several stocks with either robust growth or generous dividends, perhaps even a handful with both. But British American Tobacco’s valuation truly sets it apart right now. The company earned 371 pence per share in 2022, roughly $4.59, valuing ADR shares at a price-to-earnings ratio (P/E) of 7.

Since British American Tobacco does business in many markets worldwide, emphasizes new-category products, and is projected to grow earnings by a mid-single-digit rate moving forward, I am using Philip Morris International as a peer for comparison. You could argue that British American Tobacco is a superior/inferior company to Philip Morris, but the vast gulf in valuation between the two seems suspect.

At a P/E of just 7, British American Tobacco seems priced like a dying company, and you’ve seen above that’s not the case.

Take the stock’s potential dividend and earnings-driven 13% to 14% annual returns and add whatever potential valuation upside you deem appropriate. It’s easy to get to annual returns in the high teens or higher, even if British American Tobacco never reaches par with a stock like Philip Morris.

Nobody knows how long British American Tobacco stock will remain unloved by Wall Street, but patient investors could be looking at a big score if sentiment shifts in the right direction. The stock can stay hated by the market, and double-digit returns are almost a shoo-in.

British American Tobacco is what some might call a fat pitch, so swing the bat.

— Justin Pope

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Source: The Motley Fool