FTSE 100 tobacco and nicotine products manufacturer British American Tobacco (LSE: BATS) is a cornerstone of my passive income investments.
These have been made with the sole intention of making me big income with little daily effort on my part.
This, in fact, is the heart of the passive income investment idea. And as Warren Buffett put it: “If you don’t find a way to make money while you sleep, you will work until you die.”
Should you invest £1,000 in British American Tobacco right now?
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How much can be made?
The company raised its dividend in 2023 by 6% from 2022 — to 230.89p a share. On the current £23.30 share price, this yields 9.9% — one of the highest in the FTSE 100.
So, 858 shares in the company would cost me around £20,000, so in the first year I would make £1,980 in dividends.
However, if I reinvested the dividends, rather than taking them out of my portfolio, I would make a lot more.
This is known as ‘dividend compounding’ and is the same principle as compound interest in bank accounts. But rather than interest being reinvested, dividend payments are.
So, if I reinvested the dividends and the yield averaged the same, I’d have £53,607 after 10 years. This would pay me £5,033 a year, or £419 a month.
On the same proviso, after 30 years I’d have £385,117, paying me £36,158 a month, or £3,013 every month in passive income!
Inflation would reduce the buying power of my money, of course. But it shows that smaller investments in the right stocks can make much bigger returns over time if the dividends are reinvested.
Is a high yield sustainable?
The level of dividends paid by a firm depends on its earnings and profits over time. If these decline, then the chances are that the dividends will drop as well.
However, British American Tobacco looks in good health to me as it transitions from tobacco products to nicotine replacements.
Its adjusted profit from operations in 2023 rose 3.1% from 2022 to reach £12.47bn. Adjusted diluted earnings per share (EPS) increased 4% over the same period to 375.6p. And adjusted net debt fell 7.4% to £33.94bn.
One risk here is that its transition away from traditional products is delayed for some reason. Another is any litigation from the effects of its products in the past.
However, the shares already look to be trading at a substantial discount against their peers. This should hopefully reduce the risk of a further major fall in the stock price wiping out my dividend gains.
Specifically, the company trades on the key price-to-earnings (P/E) stock valuation measurement at just 6, against a peer group average of 12. This looks very cheap to me.
A discounted cash flow analysis shows the stock to be around 52% undervalued at the present price of £23.30. Therefore, a fair value would be around £48.54.
The shares may not necessarily ever reach that point, but it underlines to me that they look very good value.
I bought a chunk of the stock at a lower level than its current price, so am happy with that position.
If I didn’t have it, I’d absolutely buy it now for the high yield supported by an undervalued share price and a strong business outlook.
