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Should you buy this FTSE 100 giant for its massive 7% dividend yield?

Shares in tobacco group Imperial Brands (LSE: IMB) currently yield 7% on a forward basis, making the company one of the best income stocks in the FTSE 100. The question is, does this market-beating dividend yield make the stock a good buy for your portfolio? Today I’m going to take a look. 

Out of favour 

Generally speaking, when a stock is trading at a deep discount to the broader market, it is a signal that investors believe the company in question has serious problems. So, it is vital to establish what’s driving sentiment.

Shares in Imperial are currently trading at a forward P/E of just 10.6, compared to the global tobacco sector average of 14.6. They also support a dividend yield of 7%, which is more than double the market median of 3.3%.

The way I see it, two large shadows are overhanging the group — the well-documented decline of smoking and Imperial’s sluggish response to this threat. 

While the company’s peers have been investing heavily in so-called reduced-risk tobacco products (such as heat-not-burn cigarettes), Imperial has been concentrating its efforts on products like electronic cigarettes. The market for these products isn’t small (there were around 3m users of electronic cigarettes in the UK last year), but in contrast to larger peers, Imperial’s spending on diversification has been limited, which is leading some analysts to voice concerns about the group’s long-term outlook. 

Still, concerns that the tobacco industry is on the rocks are nothing new. For the past four decades, tobacco sales have been in decline, but companies have only become more profitable by using tricks such as increasing prices and shortening cigarettes to improve margins. 

Imperial is no exception. Analysts expect earnings per share to rise to 270p for 2019, up from 183p for 2017. If the company hits these targets (and based on its recent trading updates there’s no reason to believe it won’t), analysts think there is scope to increase the dividend 10% per annum for the next two years, giving a dividend of 204p per share or a yield of 7.1% by 2019. With dividend cover of 1.3 times, despite concerns about the firm’s outlook, I believe the dividend is here to stay

Imperial’s dividend looks to me to be sustainable, but one distribution I’m not so sure about is that of FTSE 100 peer SSE (LSE: SSE)

Reward vs. risk

At the time of writing, shares in SSE support a dividend yield of 7.6%. For 2019, analysts have pencilled in a modest 3.1% increase, which indicates a forward yield of 7.8% is on offer. However, unlike Imperial, which has operations around the world and an operating profit margin of nearly 8%, SSE’s business is located primarily in the UK, and its profit margin of 4.4% (for fiscal 2018) is tightly controlled by regulators. 

I’m always wary of becoming involved with companies that either depend on income from, or are regulated strictly by, the government. Politics can be unpredictable and doesn’t necessarily mix well with business. Recent calls from politicians to nationalise the rail and utility industries are great examples. 

With this being the case, yes the shares in SSE might be cheap (forward P/E of 10.6) but I believe this valuation does not make up for the risks and uncertainties surrounding the business. Imperial offers a similar level of income with a much more attractive risk/reward profile in my opinion.

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Rupert Hargreaves owns shares in Imperial Brands. The Motley Fool UK has recommended Imperial Brands. 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.