Shares in British American Tobacco (LSE:BATS) trade at a price-to-earnings (P/E) ratio of six, putting the stock firmly in value territory. Over the last 12 months, the share price has fallen by 23%.
A 9% dividend yield is eye-catching, but also a sign that investors are pessimistic about the stock. So is there a potential buying opportunity here, or should investors like me stay out of the way?
Smoking
Let’s cut straight to the chase – the company makes its profits by selling tobacco products. There’s no way around that, nor is there any way to avoid the obvious risk that the outlook for smoking isn’t positive.
This is especially true in the geographies (Europe and the US) that British American Tobacco gets most of its revenues from. So sales volumes in these categories are likely to decline steadily going forward.
It’s worth noting that the company has grown its dividend for over 25 consecutive years. But investors should be aware that the past probably isn’t a good guide to the future when it comes to smoking.
This leaves investors with two important questions. The first is how long it will be until cigarette revenues dry up entirely, and the second is where the company will be when they do.
Outlook
Looking further ahead, the company seems to be making good progress with its replacement products. Sales in these categories are growing and the division is close to turning a profit.
Management estimates that revenues from new categories will reach £5bn in a couple of years. This is encouraging, but investors should also consider what’s going to happen between now and then.
The short answer is that the company is expecting to generate £40bn in free cash over the next five years. With a £55bn market cap, that means the business is aiming to offer a 73% return before 2028.
Is there another FTSE 100 stock that has the same short-term prospects? I’m not convinced there is, and using the cash to restart its share buyback programme should help the company over the long term.
A stock to buy?
The market seems to think that British American Tobacco is a lost cause. And not without reason – the company is clearly at a crossroads and a degree of uncertainty about its future is entirely justified.
It’s also possible, though, that investor pessimism is causing the stock to trade below its intrinsic value. While tobacco sales are likely to decline, they aren’t likely to go away next year.
I think investors ought to look carefully at British American Tobacco shares at today’s prices before deciding it’s not worth bothering with. A few things are set to go the company’s way in the near future.
Improvements in the balance sheet, the possibility of share buybacks and a 9% dividend are all positive. I’m keeping an eye on this stock, but I think it could well be good value at today’s prices.
