A 9.5% yield but down 11%! Is this overlooked FTSE 100 stock an unmissable bargain?

This FTSE 100 heavyweight pays one of the highest dividends in the index, looks extremely undervalued to me, and has strong growth prospects.

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The broad devaluation of the FTSE 100 after 2016’s Brexit decision has provided multiple investment opportunities, in my view.

Many companies continue to trade well under their fair value, for example. And given that yields rise as share prices fall, others now pay very high dividends.

British American Tobacco (LSE: BATS) is one share that covers both bases, I think.

Big dividend payer

The average yield in the FTSE 100 now is 3.6%, but British American Tobacco’s is a stunning 9.5%.

So £11,000 (the average UK savings amount) would make £1,045 in first-year dividend payments. Over 10 years, that would add another £10,450 to the initial £11,000 investment.

Much more could be made by using the dividends paid to buy more of the stock – known as ‘dividend compounding’. Given the same average 9.5% yield, this would produce an extra £16,261 instead of £10,450.

Over 30 years on that yield, the total investment would be worth £167,423. This would pay £15,905 a year in dividends, or £1,325 each month.

Is a high dividend sustainable?

Growth in earnings and profits are the keys to increases in dividends over time.

In British American Tobacco’s case, adjusted operational profit last year rose 3.1% from 2022 — to £12.47bn. Adjusted diluted earnings per share increased 4% over the same period to 375.6p.

A risk in the shares is that its ongoing transition to nicotine substitute products falters, allowing its competitors to gain an advantage. Another is legal action arising from the negative health effects of its tobacco products in the past.

However, consensus analysts’ expectations are that its earnings will soar by 51.5% a year to the end of 2026.

This is reflected in analysts’ forecasts for rising dividend payments over that period. These are for 236.70p a share this year, 246.5p in 2025, and 258.8p in 2026.

This would give respective yields on the current £24.35 share price of 9.7%, 10.1%, and 10.6%.

A huge bargain?

Even better is that this enormous passive income potential can be secured for a bargain-basement price, in my view.

A key measurement of a stock’s relative value to other shares is the price-to-earnings (P/E) ratio. British American Tobacco currently trades at a P/E of 6.8 compared to a peer group average of 13.4. So it is very undervalued on this basis.  

To find out by how much, I ran a discounted cash flow analysis using other analysts’ figures and my own.

This shows the company to be 52% undervalued at its present price of £24.35. Therefore, a fair value per share would be £50.73.

Nothing is certain in financial markets, of course, but this underlines to me that it looks a huge bargain currently.

Will I buy more?

British American Tobacco ticks all three boxes I require to invest in a stock.

First, it has a very high yield that gives me a regular stream of sizeable dividend payments. Second, it looks extremely undervalued against its peer group’s shares. And third, its core business looks solid and set for ongoing growth.

These are the reasons why I thought the stock was unmissable when I first bought it a while ago. And they remain the reasons why I will be adding to this holding very shortly.

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.

Simon Watkins has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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