Does British American Tobacco 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 up81%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 British American Tobacco (LSE: BATS) (NYSE: BTI.US), to see if it might fit the bill.

The triple-yield test

Today’s low 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:

British American Tobacco Value
Current share price 3,205p
Dividend yield 4.4%
Earnings yield 6.8%
Free cash flow yield 5.7%
FTSE 100 average dividend yield 2.8%
FTSE 100 earnings yield 5.7%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.7%

A share’s earnings yield is simply the inverse of its P/E ratio, and BAT’s earnings yield of 6.8% reflects its P/E rating of 14.7, which is slightly below the FTSE average of 17.5.

Manufacturing and selling premium brand cigarettes is an extremely profitable business that does not require heavy capital expenditure, and this is reflected in BAT’s free cash flow yield of 5.7%, which represents 84% of its 6.8% earnings yield. This means that 84% of the firm’s earnings per share are converted into surplus cash, covering BAT’s 4.4% dividend yield 1.3 times.

BAT’s 2013 full-year dividend of 142.4p was 5.6% higher than in 2012, but investors should note that the pace of dividend growth is slowing. BAT’s dividend has risen by an average of 15% per year since 2007, but is only expected to rise by 3.0% in 2014.

Is BAT a buy?

Although BAT’s tobacco volumes have fallen by almost 15% since 2003, it remains a firm favourite with income investors, thanks to its strong cash generation and rising dividend.

The firm spends much of its free cash flow on buying back shares, which has helped to ensure that both earnings per share and the dividend keep on rising. However, while I think that this approach will protect the firm’s dividend for several more years, I am less confident about its share price, and expect to see BAT’s yield gradually rise as earnings growth becomes harder to sustain.

Given this risk, I rate BAT has a hold.

Today's top income choice?

Although I rate British American Tobacco quite highly as an income stock, its dividend and earnings growth are expected to slow over the next year or so.

I believe that there are now better alternatives for yield-seeking investors, including the five stocks selected for "The Fool's Five Shares To Retire On". The five hand-picked companies in this exclusive report currently offer an average prospective yield of 4.3% and all have strong long-term growth prospects.

This report is completely FREE and could transform your portfolio -- to get your copy, simply click here now.

> Roland does not own shares in British American Tobacco.