The Buffett Bull Case For British American Tobacco plc

Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

Today, I’m considering whether FTSE 100 cigarettes giant British American Tobacco (LSE: BATS) (NYSE: BTI.US) is a wonderful company, and whether its shares are trading at a fair price.

A wonderful company?

Back in the late 1980s Buffett said: “I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty”. At the same time, he said: “I’m wealthy enough where I don’t need to own a tobacco company and deal with the consequences of public ownership”.

British American Tobacco (BAT) owns some 200 cigarette brands and is the world’s most international tobacco company with leadership in more than 60 markets. These are Buffett wonderful-company qualities and underpin the fundamental numbers within the table below.

  2008 2009 2010 2011 2012
EBIT (£bn) 4.0 4.7 5.3 5.9 6.1
Operating margin (%) 30.6 31.1 33.3 32.9 33.6
ROE (%) 30.4 33.2 32.7 38.0 42.8

Source: Morningstar

EBIT (earnings before interest and tax), operating margin and ROE (return on equity) are impressive and trending upwards — testament not only to the strength of BAT’s position within its markets, but also to the quality of the company’s management.

Buffett puts a lot of store in managers with a passion for, and long-term commitment to their companies. BAT’s chief executive, Nicandro Durante, has been with the group since 1981, becoming chief operating officer in 2008 and chief exec in 2011.

A fair price?

Buffett values businesses as if he was buying the whole company. Enterprise value (EV)/EBIT is a simple whole-company metric that Buffett uses — even if his ultimate valuation is far more nuanced, involving art as well as science.

EV consists of a company’s market capitalisation, plus net debt or minus net cash. Put another way, the price you’d have to pay to buy the whole company debt-free. BAT, at a share price of 3,295p, is trading on an EV/EBIT of 11.8.

Now, Buffett may prefer a bargain EV/EBIT down in single figures, but he’s certainly prepared to keep holding wonderful companies like BAT on — or even above — this kind of rating. Therefore, I’d say BAT is currently trading at a price that Buffett might reasonably consider to be within a range of fair value.

Buffet's big UK bet

Buffett rarely invests outside his home US market, but has backed one well-known UK business big-time. The multi-billionaire now owns over 5% of this company's shares.

If you'd like to learn all about Buffett's big UK bet, you may wish to read this exclusive in-depth report. The report is 100% free and can be in your inbox in seconds - simply click here.

G A Chester does not own any shares mentioned in this article.