Does Imperial Tobacco Group plc Pass My Triple Yield Test?

british american tobacco / imperial tobacco

Like most private investors, I drip feed money from my earnings into my investment account each month. To stay fully invested, I need to make regular purchases, regardless of the market’s latest gyrations.

However, the FTSE 100 is up 75% on its March 2009 low, and the wider market is no longer cheap — it’s getting harder to find shares that meet my criteria for affordability.

In this article, I’m going to run my investing eye over Imperial Tobacco Group (LSE: IMT) (NASDAQOTH: ITYBY.US), to see if it might fit the bill.

The triple yield test

Today’s interest rates mean that shares have become some of the most attractive income-bearing investments available.

To gauge the affordability of a share for my portfolio, I like to look at three key trailing yield figures — the dividend, earnings and free cash flow yields. I call this my triple yield test:

Imperial Tobacco Value
Current share price 2,340p
Dividend yield 5.0%
Earnings yield 9.0%
Free cash flow yield 6.7%
FTSE 100 average dividend yield 2.9%
FTSE 100 earnings yield 5.8%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.8%

A share’s earnings yield is simply the inverse of its P/E ratio, and makes it easier to compare a company’s earnings with its dividend yield. Imperial Tobacco’s 9% earnings yield highlights its low P/E rating of 11, which in my view is appropriate for a company selling a product for which demand is in structural decline.

However, although Imperial’s total stick volumes may have fallen by 7% last year, tobacco remains a highly profitable business to be in. The company’s 5% dividend yield is amply covered by its 6.7% free cash flow yield, make it a favoured choice amongst pension funds and retirement investors.

My only real reservation about Imperial, from a financial perspective, are its debts. The firm’s net gearing of 166% is very high, and despite interest rates on corporate debt being at record lows, Imperial spent £522m on interest payment last year, which equates to 22% of its operating cash flow.

Is Imperial a buy?

I suspect it will be a decade or more until declining tobacco volumes really start to hurt the big tobacco companies, and in the meantime, they may find alternative ways of making money, such as “vaping” (smoking an electronic cigarette), which is exploding in popularity, thanks to its perceived safety and lack of regulation.

From an ethical standpoint, Imperial Tobacco may be questionable, but as an income investment, it’s hard not to view it as a buy. Debt concerns aside, Imperial, like its peer British American Tobacco, is simply a cash machine.

The best tobacco dividend?

Imperial Tobacco's dividend is expected to rise by 9.4% in 2014, and the firm's payout has risen by a massive 177% since 2004.

I rate Imperial very highly as an income stock, but you don't have to take my word for it -- in "How To Create Dividends For Life", the Motley Fool's expert analysts explain how to use their 'five golden dividend rules' to test the quality and strength of firm's dividend.

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