This Model Suggests British American Tobacco plc Could Deliver A 10.5% Annual Return

Roland Head explains why British American Tobacco plc (LON:BATS) could deliver a 10.5% annual return over the next few years.

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One of the risks of being an income investor is that you can be seduced by attractive yields, which are sometimes a symptom of a declining business or a falling share price.

Take British American Tobacco (LSE: BATS) (NYSE: BTI.US), for example. The firm’s 4.3% prospective yield is attractive, but, 4.3% is substantially less than the long-term average total return from UK equities, which is about 8%.

BAT’s share price is up by 8.7% so far this year, somewhat underperforming the FTSE 100’s 10.8% gain. Will BAT’s performance continue to keep pace with the index, or will this cigarette manufacturer’s declining sales gradually erode its valuation?

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What will BAT’s total return be?

Looking ahead, I need to know the expected total return from British American Tobacco shares, so that I can compare them to my benchmark, a FTSE 100 tracker.

The dividend discount model is a technique that’s widely used to value dividend-paying shares. A variation of this model also allows you to calculate the expected rate of return on a dividend-paying share:

Total return = (Prospective dividend ÷ current share price) + expected dividend growth rate

Here’s how this formula looks for British American Tobacco:

(143.2 ÷3298) + 0.0613 = 0.105 x 100 = 10.5%

My model suggests that BAT shares could deliver an annual total return of 10.5% over the next few years, modestly outperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.

Isn’t this too simple?

One limitation of this formula is that it doesn’t tell you whether a company can afford to keep paying and growing its dividend.

My preferred measure of dividend affordability is free cash flow — the operating cash flow that’s left after capital expenditure, tax costs and interest payments.

Free cash flow = operating cash flow – tax – capital expenditure – net interest

BAT’s free cash flow last year was a whopping £3.5bn, comfortably covering the £2.8bn it paid out in dividends.

Although BAT’s sales are likely to continue to decline, its 35% operating margin, ongoing share buybacks and pricing power means that the tobacco giant is expected to continue growing its dividend by around 6% per year for the foreseeable future.

In my view, BAT remains a sensible income investment, but its long-term prospects are less certain, and I’m not sure it offers the long-term growth and reliable income I want for my retirement portfolio.

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Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

> Roland does not own shares in British American Tobacco.

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