Since the middle of 2017, shares of British American Tobacco (LSE: BATS) have lost more than 57% of their market value, declining from 5,600p to only 2,984p at the time of writing. Many investors are concerned that the changing regulations would push the stock down further. However, I believe that the negative market overreaction creates an opportunity to buy into this global tobacco giant.
Market overreaction on menthol ban
The negative market impact came from the proposed menthol ban by the U.S. Food & Drugs Administration. BATS has a U.S. market-leading position with several cigarette brands. One of its big brands is Newport, the dominant menthol cigarette brand, with a 14% market share in the U.S. The other two brands are Camel and Pall Mall, with an 8% and a 7% market share, respectively.
As nearly 40% of the company’s revenue are generated in the U.S., a ban on menthol cigarettes would definitely affect its overall operating performance. However, because of the lengthy legal process that FDA needs to follow, I’d think that the ban might take at least five years to get implemented. Thus, the company has five more years to switch its loyal customers to other alternative smoking products. It also means that it takes at least five years for BATS to feel the impact on its operating performance. The market has overreacted on the news, which has not affected the company’s profits yet.
Sleep well with safe dividends and cheap valuation
In 2018, BATS paid 195.2p per share in dividends. In the next two years, BATS is expected to consistently increase dividend payments. By 2020, the dividend per share could reach 221p. At the time of writing, its dividend yield is high, at 7.13%. In the past five years, BATS has paid 67% to 89% of its earnings in dividends. In 2020, the payout ratio is expected to be quite reasonable at 67%. Thus, I reckon BATS’ dividend is safe for investors.
After the market plunge, BATS is valued cheaply in the stock market. Its forward price-to-earnings (P/E) ratio is only 9.3x, much lower than its five-year-average P/E of 15x. By 2020, BATS estimated that its earnings per share (EPS) would be 332p. If BATS is valued at 15x price-to-earnings at that time, its share price would be 5,000p, a 67% upside from the current price.
I’d believe the recent market plunge creates once-in-a-lifetime opportunity for investors to buy into this global leading tobacco giant at a very cheap price. My expectation for the BATS share price is to deliver a 67% gain within in the next two years. While waiting for the upside, investors can enjoy a juicy 7% dividend yield annually.
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Neither Anh nor The Motley Fool UK have a 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.