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

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?

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.

The ultimate income stock?

BAT remains a popular choice for income, but it didn't make the final cut for the Motley Fool's exclusive special report, "Today's Top Income Stock".

The company featured in this report offers a future-proof business model, a 5.5% prospective yield and a far more modest valuation than BAT.

If you are looking to diversify your portfolio away from its tobacco addiction, then I'd strongly recommend you take a look at this special dividend report --it's completely free, but availability is limited, so click here now to get your copy today.

> Roland does not own shares in British American Tobacco.