Imperial Tobacco Group PLC Could Be Worth 2,900p

Ethical investment is a topic that, by its very nature, splits opinion.

Some investors refuse to invest in companies such as Imperial Tobacco (LSE: IMT) (NASDAQOTH: ITYBY.US), while others will invest in most sectors so long as they are a sound investment.

Indeed, both arguments foster fierce debate. However, from a purely investment perspective (ie, putting ethical issues to one side), Imperial Tobacco seems to offer considerable potential for significant gains over the medium to long term.

Of course, being a mature company operating in a very mature market, Imperial Tobacco naturally has strong free cash flow. However, I was pleasantly surprised to find that its free cash flow yield is a whopping 8.2%. This not only trumps a great number of large-cap peers, it also shows that there is the potential for gains of around 26% over the medium to long term.

Indeed, were the free cash flow yield to fall to a still very impressive 6.5%, it would mean shares trading at around 2900p.

And this seems to be achievable, because 6.5% is still a highly attractive free cash flow yield (especially when the Bank of England base rate remains at a historic low) and it is not as though free cash flow was unusually strong last year –  it’s been consistently high in each of the last 5 years.

Furthermore, Imperial Tobacco continues to offer a relatively high yield of 5.5%, so even if shares do take some time to reach 2900p, investors should be rewarded for holding via an above-average yield.

However, it appears as though this yield could be even better, with Imperial Tobacco being rather mean with regards to the proportion of earnings that it pays out as a dividend.

The payout ratio for last year was just 55%. For a mature company with such strong cash flow, this is rather low and a payout ratio of two-thirds or more could be a more likely long term level. Such a payout ratio would mean its shares paying a dividend of around 140p, putting Imperial Tobacco on a yield of 6.1% at current price levels.

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> Peter does not own shares in Imperial Tobacco.