This P/E Suggests British American Tobacco plc is a Hold

The FTSE 100 has risen by more than 60% since it hit rock bottom in 2009, and bargains are getting harder to find, despite the market’s recent losses.

I’m on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I’m using a special version of the price to earnings ratio called the PE10, which is one of my favourite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last ten years. This lets you see whether a company looks cheap compared to its long-term earnings.

Today, I’m going to take a look at the PE10 big tobacco firm British American Tobacco (LSE: BATS) (NYSE: BTI.US).

Impressive returns

Anyone who thinks that you need to invest in small companies to achieve big returns should look closely at BAT.

The tobacco firm’s share price has risen by 456% over the last ten years, while dividend payout has risen from 38.8p in 2003, to 134.9p per share in 2012 — a 247% increase.

As a result, the firm’s shares have traded on a premium P/E for some years, as they continue to do:

British American Tobacco 17.8 31.5

Falling volumes

There’s a long-running argument that tobacco firms’ businesses will eventually decline, as a combination of legislation and education gradually stops people smoking.

It’s certainly true that BAT doesn’t sell as many cigarettes as it used to. In 2003, BAT sold 792 billion cigarettes. By 2012, this had fallen to 694 billion, a 12% fall.

To counter this, BAT focuses ruthlessly on improving its profitability, targeting a 0.5% – 1% rise in operating margin each year. In 2012, it managed to increase its operating margin by 1.6%, to 37.4%.

BAT is also a big fan of share buybacks. The firm repurchased £1.25bn of its own shares in 2012, and is planning to repurchase £1.5bn in 2013. This combination of rising margins and share buybacks has enabled BAT to deliver strong earnings and dividend growth over the last decade, but it cannot work forever, especially if cigarette volumes continue to decline.

Is BAT a buy?

Although I believe that BAT’s profits will eventually start to decline, I think this could take longer than you might expect.

I think that investors have seen the best of the capital gains from BAT shares, while for income, I rate them as a hold.

If you already own shares in BAT, then I’d strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top UK fund manager Neil Woodford’s eight largest holdings, which include BAT.

Mr. Woodford’s track record is impressive: if you’d invested £10,000 into his High Income fund in 1988, it would have been worth £193,000 at the end of 2012 — a 1,830% increase!

This special report is completely free, but availability is limited, so click here to download your copy immediately.

> Roland does not own shares in any of the companies mentioned in this article.