FTSE 100 income share British American Tobacco (LSE: BATS) offers one of the most generous dividend yields in the market. And, as the stock still trades at a valuation that feels to me to be stuck in the past, share price gains may be possible too.
A risk here is any slip in its transition to smokeless nicotine substitutes. This could allow its competitors doing the same thing to gain an advantage. Another is any tightening of regulation in key markets, which could limit its ability to raise prices.
Nevertheless, forecast dividend rises and potential share price gains are underpinned by solid earnings growth forecast at 4% a year over the medium term.
So, what sort of gains could investors be looking at?
Rising dividend yields forecast?
British American Tobacco has increased its dividend steadily from 210.4p in 2020 to 240.24p last year. These generated respective annual average yields of 7.8%, 7.9%, 6.7%, 10.1%, 8.2%, and 5.8%.
The current dividend return is 5.6%, but analysts forecast this will rise to 6.1% this year, 6.2% next year, and 6.5% in 2028. Of course, yields can go down as well as up over time.
On this 6.5% yield, my £20,000 holding in the stock would make £18,244 in dividends after 10 years and £119,836 after 30 years. This also assumes ‘dividend compounding’ being used (that is, the dividends being reinvested in the stock).
On these twin bases, the holding’s value would be £139,836 after the 30-year period. And by that point, my holding in British American Tobacco would be paying a yearly income of £9,089!
Potential share price gains?
In addition to delivering high yields, the income shares I buy always look underpriced to their ‘fair value’. The number represents the true worth of the underlying business, while price is just whatever the market will pay at any point.
This point is critical for long-term profits because share prices tend to converge to their fair value over time.
Discounted cash flow (DCF) analysis attempts to anchor a stock’s value by estimating the cash it will generate in the years ahead. It then discounts those amounts back to the present. As those earnings forecasts become less certain, investors demand a higher return, which increases the discount rate.
Because analysts use different inputs, their DCF valuations vary — some more upbeat than mine, others more cautious. Based on my own assumptions, including a 9% discount rate, British American Tobacco’s shares are 36% undervalued at their current £43.16 price.
That suggests a fair value closer to £67.44 — significantly higher than today’s level. Should prices continue gravitating towards fair value over time, this may represent an excellent buying opportunity if those DCF assumptions prove accurate.
My investment view
I have held the stock for several years, during which time it has gained substantially in price and delivered recurring high dividends.
Forecast solid earnings growth should keep supporting rises in both. And the long‑term maths of compounding only strengthens the total returns picture.
Given these factors, I will be adding to my holding very soon. My attention has also been caught recently by similarly undervalued high-income stocks, albeit in different FTSE sectors.
