British American Tobacco‘s (LSE:BATS) yield of 9.3% is something of an outlier. The average for the FTSE 100 is 3.9%, which I think makes the company worthy of further investigation.
British American Tobacco has a long history of rewarding its shareholders with generous dividends. It makes quarterly payments and has increased its payout every year since 2018.
A wolf in sheep’s clothing?
But I wonder if the stock is a value trap, something that looks like a bargain but, in reality, isn’t.
When valuing companies, it’s useful to make a comparison to a similar business. Imperial Brands has a near-identical operating model which makes it a good benchmark.
Both companies have comparable price-to-earnings ratios of 6.5-7.
But when it comes to the price-to-book (P/B) ratio, one appears to be more of a bargain.
At 31 March 2023, Imperial Brands had net assets of £6.2bn, giving it a P/B ratio of 2.5.
British American Tobacco’s balance sheet at 30 September 2023, showed a book value of £72.6bn. This means its P/B ratio is presently 0.8. Therefore, its current stock market valuation doesn’t accurately reflect its underlying assets.
But that’s the point of a value trap.
I might be tempted to buy a stake in British American Tobacco because its shares appear to be cheaper than its closest rival. And who wouldn’t want to earn income of 9.3% on an investment?
Not for me
But there are two reasons why I don’t want to include the stock in my portfolio.
Firstly, the company still earns the majority of its revenues from traditional tobacco products. And these are falling out of favour around the world.
Rishi Sunak recently announced his intention to pass legislation meaning anyone currently aged under 14 will never be able to buy cigarettes.
To combat this, the company’s investing heavily in so-called reduced-risk products but some of these are also facing bans and restrictions. At the moment these are loss-making and account for just 12% of revenue.
Secondly, I have concerns that the stock is falling out of favour as the number of ethical investors increases.
According to Bloomberg, socially responsible investments will account for a third of all assets under management by 2025. The long-term share price performance of British American Tobacco has been disappointing, possibly due to this trend.
Since October 2018, the company’s paid £10.60 per share in dividends.
However, its share price has fallen 32%. This means £10,000 invested five years ago would now be worth £6,800.
But I’d have earned £3,212 in dividends meaning I’d be in the black by £12! Not a great return over such an extended period.
Others have done better
Contrast this with the performance of, for example, Frasers Group, which doesn’t pay dividends. Understandably, income investors don’t like the stock but its share price has increased 150% over the past five years, which would have turned £10,000 into £25,000.
There’s little point owning a high-yielding stock if its value is diminishing.
For these reasons I think British American Tobacco shares are something of a value trap and that there are better opportunities elsewhere.
James Beard has positions in Frasers Group Plc. The Motley Fool UK has recommended British American Tobacco P.l.c. and Imperial Brands Plc. 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.
Motley Fool UK 2023