British American Tobacco (LSE: BATS) may not be the flashiest name in the FTSE 100. But for income investors, it remains one of the index’s most reliable cash engines.
Its mature portfolio continues to throw off hefty free cash flow, supporting a dividend yield that outpaces the wider market.
The shares also trade at a significant discount to their fair value, so there could be serious capital gains too.
But what sort of returns are we looking at here?
Earnings growth drivers
Ultimately underpinning any gains in dividends and share price is earnings (‘profits’) growth. A risk to the group is any slippage in its transition to smoke-free products. This could give an advantage to competitors doing the same thing. Even so, analysts forecast that British American Tobacco’s earnings will grow by an average 4% a year over the medium term.
The firm’s 2025 results, released on 12 February, look broadly supportive of this. Revenue rose 2.1% year on year to £26.4bn, underlining the strength of the group’s multi-product model.
Adjusted operational profit increased 2.3% to £11.6bn. Margins were supported by disciplined pricing, improving new categories (mainly nicotine substitutes) contribution and continued productivity gains.
Free cash flow before dividends came in at £4bn, which can be a major driver of growth. Management reiterated that it expects 4%–6% growth in adjusted profit this year.
Share price potential
A discounted cash flow (DCF) analysis shows British American Tobacco shares are 37% undervalued at their current £42.85 price. So, their ‘fair value’ is £68.02.
This gap between the stock’s price and its value is extremely important for the profits of long-term investors. This is because share prices tend to converge to their fair value over time.
So the wide gap between the two measures here suggests a potentially terrific buying opportunity to consider today if those DCF assumptions hold.
DCF modelling involves projecting a company’s future cash flows and then discounting them back to today. And this also reflects consensus analysts’ earnings growth estimates for the firm.
Analysts’ DCF modelling varies — some more conservative than mine — depending on the variables used.
Nevertheless, the method produces a clean, standalone valuation, unaffected by over- or undervaluations across an entire business sector.
Dividend income potential
I regard any share price gains in stocks I hold for their dividend potential as a bonus. In British American Tobacco’s case, the income generated in this way has been enormous over the years.
Dividends increased from 210.4p in 2020 to 2025’s 240.24p. These provided respective annual average yields from 2020 of 7.8%, 7.9%, 6.7%, 10.1%, 8.2%, and 5.8%.
The current dividend yield is 5.6%, but analysts forecast this will rise to 5.9% this year, 6.1% next year, and 6.4% in 2028. But of course, returns can go down as well as up over time.
On this 6.4% yield, my £20,000 holding could make a not-guaranteed £17,866 in dividends after 10 years and £115,725 after 30 years. This also reflects the dividends being reinvested in the stock to harness the power of ‘dividend compounding’.
By the end of the 30 years, the holding’s value could be £135,725. And this could pay a yearly dividend income of £8,686!
Given its strong dividend returns and potential share price gains, I will buy more of the shares soon.
