British American Tobacco (LSE: BATS) was one of a clutch of FTSE 100 stocks I picked up in early 2020. With early retirement in mind, I focused on high‑dividend shares to fund the fun of future downtime.
Back then, the tobacco and nicotine substitutes manufacturer was yielding 8.8%. Since then, the share price has climbed strongly, compressing the yield, but I am well ahead on both income and capital.
So, what are the prospects for further gains?
A bargain-basement bonanza
I bought £10,000 worth of the stock in late March of that year. That secured me 417 shares at the then price of £23.97.
From that point, the firm has delivered total dividends per share of £12.90. So, I have made £5,379 in these payouts from those 417 shares since then.
However, I have seen paper gains (as I have not sold the stock) as well. With the shares now trading at £42.82, they have jumped 79%!
That means I am currently sitting on an unrealised capital gain of £7,856.
Together with the dividends, this gives me a total gain of £13,235 – a rise of around 132% on my initial investment.
What’s the price outlook?
It is crucial to note here that a share’s price can still be undervalued even if it has risen enormously.
This is because price and value are different things. The former is just a function of what the market is willing to pay at any point. But the latter is based on the fundamentals of the underlying business.
In British American Tobacco’s case, a discounted cash flow valuation shows it is 30% undervalued at its current £42.82 price.
So, its ‘fair value’ is £61.17.
What about its dividends?
The firm has raised its dividends in each of the past five years since 2020. These have produced respective annual average yields of 7.8%, 7.9%, 6.7%, 10.1%, and 8.2%.
That sequential rising dividends have not produced sequential rising yields illustrates that yields move inversely to share price. In short, dividend yields can go up, down, or be cancelled.
A broader risk comes from any failure in the firm’s ongoing transition towards nicotine substitutes rather than tobacco products. This could squeeze its profits.
Nonetheless, analysts forecast British American Tobacco will increase its dividend to 240.2p this year, 250.4p next year, and 258.8p in 2027.
This would give yields on the current share price of 5.6%, 5.8%, and 6%.
What’s this mean for dividend income?
My original £10,000 investment at a 6% yield would make another £8,194 after 10 years. This is also provided I reinvested the dividends back into the stock (‘dividend compounding’).
After 30 years on the same basis (which cannot be guaranteed), this would rise to £50,226. With my £10,000 included, the holding would be worth £60,226.
And that would pay £3,614 a year in dividend income by that point.
My investment view
Its projected rising dividend yield and notable undervaluation remain extremely appealing to me.
Also positive are analysts’ forecasts that its earnings are set to grow by 15.4% a year to end-2027. This is the engine for stock price and dividend gains for any firm.
Consequently, I will buy more of the stock very shortly. And I also have my eye on other high-yielding shares as well.
