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Which is the better dividend stock: National Grid plc or British American Tobacco plc?

While the FTSE 100 index has recently set new highs, not every stock has benefitted. Investors have largely focused on growth stocks this year, and as a result, many dividend-paying value stocks have been left behind.

Today I’m looking at two such stocks – National Grid (LSE: NG) and British American Tobacco (LSE: BATS). Both are way off their 2017 highs at present making them better value, but which stock offers the best dividend prospects right now?

Dividend yield

A good starting place when assessing a dividend stock is to look at the yield on offer. National Grid paid its shareholders 44.3p per share last year. At the current share price of 867p, that’s a yield of 5.1%. British American Tobacco paid investors a dividend of 169.4p per share for 2016. At the current share price of 4,970p, that’s a yield of 3.4%.

National Grid clearly wins this battle. However, when analysing dividend stocks, it’s important to look beyond the headline yield.

Dividend coverage

The next thing to look at is dividend coverage. This indicates if a company can afford to pay its dividend. Dividend coverage is calculated by dividing earnings by dividends. A ratio over two is considered good. Anything under 1.5 is considered a little risky.

National Grid generated earnings from continuing operations of 56.9p last year. That equates to a dividend coverage ratio of 1.3. Meanwhile, BATS generated earnings of 248p, resulting in a coverage ratio of 1.5. The tobacco giant wins this duel.

Dividend growth

Next, we should assess dividend growth. This can have important implications for total long-term returns.

National Grid aims to increase its payout in line with RPI inflation. Over the last five years, the dividend has been increased by 13%. While that’s clearly better than no growth at all, it’s not a fantastic level.

British American Tobacco has lifted its payout by an impressive 34% over five years. Much better. Looking ahead, analysts expect another 9% growth this year, followed by 8% next year. National Grid on the other hand, is expected to increase its payout by 4% and 2%.

British American Tobacco wins this contest hands down.

Valuation

Turning to valuation, National Grid is the cheaper stock. After falling from around 1,100p in May, to 867p today, the shares now trade on a forward P/E of 14.7. British American Tobacco shares have also fallen recently, from over 5,600p in June, to under 5,000p today. The forward P/E is now 17.7.

Risks

Neither dividend stock is without risk. In National Grid’s case, investors are concerned by ongoing political risk and the talk of renationalisation. The labour party has intentions to bring national and regional grid infrastructure “into public ownership over time”.

In British American Tobacco’s case, the market has concerns over the US Food and Drug Administration’s (FDA) plans to cut nicotine in cigarettes. This could impact future profitability.

Dividend winner 

To pick the best dividend stock here is a tough call. National Grid has a higher yield, a lower valuation, but less coverage and less dividend growth potential. BATS has the lower yield, a higher valuation, but better coverage and more potential for dividend growth.

Overall, I’d lean towards the tobacco giant right now. The dividend growth on offer should help generate solid total returns. Having said that, National Grid’s 5%+ yield does look appealing at present.

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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.