Better Buy: British American Tobacco plc vs Imperial Brands plc

Both British American Tobacco plc (LON:BATS) and Imperial Brands plc (LON:IMB) have rewarded investors have rewarded shareholders with double-digit total returns over the past few years, but which stock is the better buy today?

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Tobacco giants British American Tobacco (LSE: BATS) and Imperial Brands (LSE: IMB) are hugely popular stocks with dividend investors. In terms of dividend growth and capital appreciation, there have been few investments that have performed as well as these tobacco stocks over the past decade.

Both BATS and IMB have delivered similar double-digit total annualised returns over the past 5 years. Recently, however, the two have begun to diverge in terms of their performance — since the start of this year, BATS delivered a total return of 20%, topping out IMB’s 2% total return.

With that being the case, which stock is the better buy right now?

Growth prospects

BATS appears to have better long-term growth prospects. Because BATS has a much larger presence in emerging markets (particularly in Latin America, where it controls more than half of the market) and in so-called next generation products, including e-cigarettes and other vaping products, revenues are forecast to grow faster for BATS than it is for IMB.

Although earnings growth for both companies have been quite similar in recent years, their respective volume growth figures tell a different story. Cigarette volumes have grown by 2.2% year-to-date for BATS, whereas volumes declined 3.0% for IMB for the 12 months ending 30 September 2016.

Thus, it appears that IMB has only been able to maintain earnings growth through raising prices and controlling costs to mitigate margin pressures. This has worked well so far, but the prospects of such strategy delivering robust gains in the longer run is not as promising. Going forward, I expect BATS’s earnings growth rate to outperform IMB’s.

Value or growth?

However, their different growth outlooks are very much reflected by their valuation differences. Imperial shares trade at much lower valuation multiples on its expected earnings over the next two years.

Shares in IMB trade at 12.5 times its expected 2016 earnings, whereas shares in BATS trade at 17.0 times. For 2017, there is a similar picture – IMB trades at 11.8 times its expected earnings, compared to 16.0 times for BATS. The gap in their respective dividend yields is just as significant — IMB shares currently yield 4.2%, compared to BATS’ 3.4%.

However, I think BATS has more dividend growth potential than Imperial. BATS has historically had much faster dividend growth rates in the past, and with long-term earnings growth expected to be faster for the company, BATS’ dividend growth is expected to diverge more significantly in the future. In addition, BATS is set to benefit more substantially from the weaker pound, because more than 80% of its earnings come from outside the UK.

Bottom line

Which stock is the better buy for you ultimately depends on whether you’re looking for a higher current yield or if you’re searching for better long-term growth.

While IMB’s growth outlook doesn’t seem quite as impressive as BATS’, Imperial’s stock offers much better value. And as I’m a value investor, I’ll probably go for IMB right now. But if BATS share price were to pull back under 4,000p, I may have to think again.

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.

Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Imperial Brands. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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