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Can I trust this FTSE 100 income stock’s 7% yield?

Over the past few decades, British American Tobacco (LSE: BATS) has carved out a reputation for itself as one of the best income stocks in the FTSE 100, and investors have clamoured to get their hands on the shares.

However, over the past 24 months, sentiment towards the business has started to change and investors, who were previously prepared to pay a premium to buy into British American’s growth story, have been jumping ship. Over the past 12 months, the stock has underperformed the UK’s leading blue-chip index by around 18.4%, even when dividends are included.

The question is, would I follow the rest of the market and sell British American or could I trust this FTSE 100 income stock’s 7% dividend yield?

Here to stay?

Ever since scientists first made the connection between smoking and cancer, analysts have questioned whether or not tobacco companies such as British American will be able to survive. But even though the number of smokers around the world has declined dramatically over the past few decades, they have been able to do just that.

In fact, British American is more profitable today than it has ever been and analysts don’t expect the company’s growth to slow anytime soon. The City has pencilled in earnings growth of 12% for 2019 and 6.4% for 2020, which implies the stock is currently trading at a forward P/E of just 9.2 with a net profit of £7.7bn expected for 2020 and earnings per share of 333p.

Of course, there is a risk that policymakers in one of the company’s main markets could introduce new legislation that will dent growth during the next 24 months, but this has always been a risk for shareholders and so far, British American has been able to navigate through all of the regulations levelled against it.

The other primary risk to its dividend is self-inflicted. The company has a tremendous amount of debt accumulated through a string of acquisitions. This debt is manageable at the moment, but it could limit the group’s financial flexibility. If sales suddenly take a dive, the firm might be forced to cut its dividend and divert more cash to paying down debt.

Still, with almost £4.5bn or free cash flow (after the payment of dividends) available for debt reduction last year, it looks to me as if British American has plenty of cash available to both meet obligations to creditors and reward shareholders for the foreseeable future.

Risk vs Reward 

Back at the beginning of June 2017, shares in the firm were dealing at a forward P/E of 23.6, and if you were to ask me if this is a price worth paying for the company, considering everything we know now, I would say probably not.

Today, however, the stock is trading at a forward P/E of just 9.6, which I believe is much more attractive, even considering the aforementioned risks. At this valuation, it seems to me that the market is already assuming the worst-case scenario.

With that being the case, I think the stock might be an attractive addition to an income portfolio. The dividend looks safe for the time being, and any improvement in British American’s outlook could lead to a sudden re-rating of the stock.

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Rupert Hargreaves owns shares in British American Tobacco. 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.