FTSE 100 tobacco and nicotine replacement products manufacturer British American Tobacco (LSE: BATS) is trading around its 12-month high.
As yields fall when share prices rise, the payout on the stock has fallen. However, it is still giving a return of 8.3%. This is one of the very best payouts in the FTSE 100, which currently has an average yield of 3.6%.
Such a high return can generate a very significant passive income from the dividends paid.
Payouts with no dividend reinvestment
The average UK savings amount is £11,000. This invested in British American Tobacco would pay £913 in dividends this year.
So, over 10 years if the yield averaged the same the total return would be £9,130 to add to the £11,000 initial investment. This would pay a passive income of £1,671 each year.
After 30 years, the total investment would be valued at £38,390, given the same average yield. It would generate £3,186 a year in dividend payments.
This is a lot better than would be made in a regular UK savings account. But it is nowhere near the potentially life-enhancing passive income that can be made by reinvesting those dividends back into British American Tobacco shares.
It is the same idea as compound interest in a bank account, but rather than interest being reinvested, dividends are.
Supercharging returns through compounding
Doing this would make an extra £14,155 after 10 years instead of £9,130. Added to the initial £11,000 investment, this would pay £2,088 a year compared to £1,671.
After 30 years, the total investment in the firm would be worth £131,542 rather than £38,390. It would pay £10,918 each year in passive income, not £3,186!
While yields fall when share prices rise, they can also increase if annual dividend payments are boosted.
British American Tobacco did just this in its H1 2024 results – adding 2% to the Q2 payment. It did the same for the Q1 payment too.
Factoring this into future payments, analysts expect the shares to yield 9% by end-2025 and 9.5% by end-2026.
Are the shares undervalued too?
In picking shares for my passive income-generating portfolio I also look to their relative value.
A stock that is undervalued against its peers is less likely to drop a long way for an extended period. This means there is less chance of my dividend returns being wiped out.
It also increases the chance of my being able to make some money on a rise in the share price over time.
British American Tobacco currently trades on the key price-to-earnings ratio (P/E) at just 7.5. This is very cheap compared to the average 13.8 P/E of its peers.
In fact, a discounted cash flow analysis shows the stock to be 57% undervalued at its present price of £27.90. Therefore, a fair value would be £64.88, although it could go lower or higher than that.
A risk in the shares is that the firm loses market share to its competitors for some reason. Another is any litigation from alleged ill effects of its products.
However, consensus analysts’ estimates are that its earnings will increase by 52.1% each year to the end of 2026.
I already own the stock but if I did not I would buy it today for its high yield, undervaluation, and growth prospects.
This post was originally published on Motley Fool
