After A Good Run, Is It Time To Sell Imperial Tobacco Group PLC And British American Tobacco plc?

Shares in British American Tobacco (LSE: BATS) and Imperial Tobacco Group (LSE: IMT) have gained 134% and 117% respectively, excluding dividends, since the end of 2008, outperforming the wider FTSE 100 by more than 50%. In fact, these two tobacco giants have outperformed almost all of the FTSE 100’s constituents since the financial crisis.

That’s great news. But after such impressive gains they’re both trading at premium valuations, that leave little room for error, and it could be time for investors to sell up and reinvest their profits elsewhere.

Small sector

As British American and Imperial are the only two listed tobacco companies with their primary listing here in the UK, it’s difficult to value the two companies without looking overseas. For example, at present Imperial is trading at a forward P/E of 15.1 and British American is trading at a forward P/E of 18.3. These two multiples give a sector average of 16.7, which isn’t really all that helpful. 

But by including US-listed tobacco companies in the calculation, a clearer picture emerges. Specifically, US tobacco giants Phillip MorrisAltria and Reynolds American trade at forward P/Es of 19.3, 19.3 and 20.3 respectively. So, when compared to their international peers, British American and Imperial certainly look undervalued. 

However, there’s a good reason British American and Imperial trade at a discount to their US peers. The UK tobacco giants have much tighter profit margins than those American firms. As a result, they’re unable to return as much cash to shareholders and deserve a lower valuation. Last year Imperial’s operating profit margin was a dismal 7.9%, the lowest of the group. At the other end of the scale, Reynolds American reported an operating profit margin of an impressive 67% for last year. Philip Morris’s reported operating margin was 42%, and even British American’s operating margin came in at 33% for full-year 2014. 

Historic trends

So, while British American and Imperial do deserve to trade at a discount to international peers, it’s still not clear if the shares of these companies are undervalued or overvalued at present levels. The best way to answer this question is to look at the historic valuations of each company. 

Take Imperial. During the past decade, the company has traded at an average forward P/E of 12. In fact, the only time its valuation exceeded 16 times projected earnings was briefly back in 2007 when the market was charging to new highs, unaware of the financial crisis that was just around the corner. 

Similarly, British American has traded at an average forward P/E of 14 for the past decade. There’s only been one occasion in the last 10 years when the company’s shares have traded at a valuation of more than 17 times forward earnings. So right now, that means British American’s shares are more expensive than they have been at any point in the past decade.

All in all then, it could be time to sell both after recent gains, as the two companies look to be trading at extremely stretched valuations.

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Rupert Hargreaves owns shares of Imperial Tobacco Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.