Shares in FTSE 100 heavyweight British American Tobacco (LSE: BATS) have long been a rich source of passive income for me. This is money made with little effort and as a former smoker, I feel perfectly entitled to benefit from the firm’s generosity.
It took the form last year of a 230.89p dividend, which yields 8.8% on the current £26.33 share price. By contrast, the average yield of the FTSE 100 is just 3.5% and of the FTSE 250 only 3.3%.
The undervaluation requirement
A high yield in a stock designed to maximise passive income is a very good start. But there are two other qualities I look for, beginning with undervaluation in the share price. In my experience, this reduces the chance of dividend gains being erased by share price losses if ever I sell a stock.
British American Tobacco currently looks very undervalued to me on several key relative stock valuation measures. On the price-to-sales ratio (P/S), for instance, it currently trades at just 2.3 against a competitor average of 3.2.
A discounted cash flow analysis using other analysts’ figures and my own shows the firm to be 60% undervalued now. So, a fair value for the stock would be £65.83, although it may go lower or higher than that.
The growth necessity
The third quality I want from a passive income stock is a strong business outlook. Ultimately, growth in earnings power rises in a company’s share price and dividends over time.
British American Tobacco is shifting away from combustible tobacco products and towards non-combustible nicotine replacement ones. It aims to have 50m consumers of its smokeless products by 2030. It also targets 50%+ of its revenues to be generated from the sector by 2035.
As of the end of 2023, it had 23.9m such customers accounting for 16.5% of its revenues.
The key risk for its growth prospects is that this shift in strategy stalls for some reason. Another is litigation for damages allegedly caused by smoking. Indeed, 18 October saw a Canadian court-appointed mediator propose a C$32.5bn (£18.1bn) settlement by British American Tobacco, Philip Morris, and Japan Tobacco to settle such a dispute in the country.
However, as it stands, consensus analysts’ estimates are that the firm’s earnings will grow a whopping 44.4% a year to end-2026.
How much passive income can it generate?
£6,000 invested in 8.8%-yielding British American Tobacco shares will generate £528 in dividends in the first year. Over 10 years on the same basis, this would rise to £5,280 and over 30 years to £15,840.
However, if these dividends were used to buy more of the shares, the returns could be vastly greater.
Doing this (‘dividend compounding’) on the same average yield would make £8,419 in dividends rather than £5,280. And over 30 years on the same basis, the payouts would grow to £77,273, not £15,840.
By that point, the total value of the British American Tobacco would be £83,273. This would be paying £7,328 in annual passive income, or £611 every month!
It is not guaranteed and the buying power of the money would have been reduced somewhat by inflation by then, of course. However, it underlines how relatively small investments can grow into much bigger passive income over time.
This post was originally published on Motley Fool
