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Is British American Tobacco p.l.c. (LON:BATS) A Good Fit For Your Dividend Portfolio?

Could British American Tobacco p.l.c. (LON:BATS) be an attractive dividend share to own for the long haul? Investors are often drawn to strong companies with the idea of reinvesting the dividends. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

A high yield and a long history of paying dividends is an appealing combination for British American Tobacco. It would not be a surprise to discover that many investors buy it for the dividends. Some simple analysis can offer a lot of insights when buying a company for its dividend, and we'll go through this below.

Explore this interactive chart for our latest analysis on British American Tobacco!

LSE:BATS Historical Dividend Yield, February 18th 2020
LSE:BATS Historical Dividend Yield, February 18th 2020

Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, then the dividend might become unsustainable - hardly an ideal situation. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. In the last year, British American Tobacco paid out 74% of its profit as dividends. This is a fairly normal payout ratio among most businesses. It allows a higher dividend to be paid to shareholders, but does limit the capital retained in the business - which could be good or bad.

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We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. British American Tobacco paid out a conservative 45% of its free cash flow as dividends last year. It's encouraging to see that the dividend is covered by both profit and cash flow. This generally suggests the dividend is sustainable, as long as earnings don't drop precipitously.

Is British American Tobacco's Balance Sheet Risky?

As British American Tobacco has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). British American Tobacco is carrying net debt of 4.29 times its EBITDA, which is getting towards the upper limit of our comfort range on a dividend stock that the investor hopes will endure a wide range of economic circumstances.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. British American Tobacco has EBIT of 6.35 times its interest expense, which we think is adequate.

We update our data on British American Tobacco every 24 hours, so you can always get our latest analysis of its financial health, here.

Dividend Volatility

From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. British American Tobacco has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. The dividend has been cut on at least one occasion historically. During the past ten-year period, the first annual payment was UK£0.84 in 2010, compared to UK£2.03 last year. This works out to be a compound annual growth rate (CAGR) of approximately 9.3% a year over that time. British American Tobacco's dividend payments have fluctuated, so it hasn't grown 9.3% every year, but the CAGR is a useful rule of thumb for approximating the historical growth.

A reasonable rate of dividend growth is good to see, but we're wary that the dividend history is not as solid as we'd like, having been cut at least once.

Dividend Growth Potential

With a relatively unstable dividend, it's even more important to see if earnings per share (EPS) are growing. Why take the risk of a dividend getting cut, unless there's a good chance of bigger dividends in future? British American Tobacco has grown its earnings per share at 5.6% per annum over the past five years. Earnings per share are growing at an acceptable rate, although the company is paying out more than half of its profits, which we think could constrain its ability to reinvest in its business.

Conclusion

Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. First, we think British American Tobacco has an acceptable payout ratio and its dividend is well covered by cashflow. Second, earnings growth has been ordinary, and its history of dividend payments is chequered - having cut its dividend at least once in the past. Ultimately, British American Tobacco comes up short on our dividend analysis. It's not that we think it is a bad company - just that there are likely more appealing dividend prospects out there on this analysis.

Earnings growth generally bodes well for the future value of company dividend payments. See if the 20 British American Tobacco analysts we track are forecasting continued growth with our free report on analyst estimates for the company.

We have also put together a list of global stocks with a market capitalisation above $1bn and yielding more 3%.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.