One company that regularly catches the eye of income investors is British American Tobacco (LSE:BATS).

With a dividend per share of 245.04p, investors only need to own 97 shares to unlock a passive income of £237.69 a year. At the current share price of 4,390p, that position would cost approximately £4,258.30 to build – comfortably within reach for many ISA investors.

But is it actually a good idea?

What’s the investment case?

British American Tobacco is one of the world’s largest tobacco companies, owning iconic brands including Dunhill, Lucky Strike, and Newport.

The stock currently yields around 5.7%, making it one of the more generous income opportunities in the FTSE 100. But unlike many high-yield income stocks, the payout is actually backed by substantial and highly predictable cash flows, generated from a deeply loyal customer base.

 That’s not a coincidence. Tobacco is one of the most addictive consumer products on the planet, and that dynamic translates directly into pricing power and cash generation that most businesses can only dream of.

But beyond traditional cigarettes, the group has been investing heavily in its New Categories division.

This newer line of products focuses on vapes, heated tobacco products, and nicotine pouches under brands like Vuse and Velo. And the segment is growing rapidly as a central part of management’s strategy to reposition the business away from traditional cigarettes.

The combination of new and legacy product sales continues to generate ample, sturdy cash flows. And that’s subsequently paved the way for continuous dividend hikes each year for over two decades in a row.

Needless to say, that kind of track record speaks volumes about the resilience of the underlying business model, even in the most challenging environments.

What could go wrong?

While British American Tobacco is making good progress with its transition, the company is working against the clock.

Governments worldwide are actively tightening regulations on tobacco and nicotine products at an accelerating pace. From plain packaging laws to outright bans on certain products in key markets, the regulatory headwind is real and unlikely to reverse.

This has already translated into volume declines for traditional cigarettes. And if the group’s New Categories division fails to fully offset this regulatory erosion, long-term cash flows and, in turn, dividends could come under pressure.

The bottom line

For pure income, few dividend stocks on the London Stock Exchange offer what British American Tobacco has right now.

The yield is chunky, the cash flows are formidable, and the New Categories pivot is gaining real momentum.

Obviously, there’s the ethical dimension to consider. Many investors understandably don’t like the idea of having tobacco companies in their portfolios. And that’s a completely legitimate position to take.

But for investors who don’t have such ethical objections and are comfortable with the regulatory risks, this dividend stock could be worth investigating further.

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It could – and for many people it already is. What does it take — and what sort of income might it generate?

The mechanics of dividend shares and passive income

Answering those questions requires some explanation about what dividend shares are and how they can work.

Shares can pay dividends, which are basically one way for a business to use some of its excess cash. Not all do though. Perhaps they do not generate enough excess cash, or do but choose not to spend it funding dividends – even if they have paid them in the past.

That helps explain why savvy investors spread their portfolio across a diversified range of shares and rather than just look at a share’s current payout, they try to gauge what they think it might pay in future.

How large a second income might be earned depends on how much is invested – and at what dividend yield.

Yield is basically the annual dividend earnings, expressed as a percentage of what the shares cost to buy.

Aiming for a four figure income

Say, for example, that someone earns a 5% yield. That is well above the current FTSE 100 average but, in my opinion, still well within the realms of possibility while sticking to proven blue-chip businesses.

Investing £100k at that level ought to earn a £5k second income annually. That could be done as a lump sum. Alternatively, it could be the result of drip feeding money in.

That could be £20k a year for five years – although if dividends are reinvested along the way, that timeline could speed up.

On the hunt for shares to buy

Given that dividends are not guaranteed, what sorts of shares might make sense for such a second income plan?

As I mentioned above, I think it is wise to diversify across a range of shares that look like they have strong dividend potential. For example, they may have a competitive advantage in an industry with resilient customer demand, and strong free cash flows.

It is also important not to overpay for shares. Even though a second income from dividends is the goal, the price paid matters. It affects the yield earned. Also, overpaying could mean an investment ends up resulting in a capital loss.

Here’s a share to consider

One share I think investors should consider for its income potential is British American Tobacco (LSE: BATS). Some investors may have ethical objections. Others may wonder whether the Lucky Strike maker can fend off the risk of falling cigarette sales eating into revenues, something that has already happened for a couple of years in a row.

I recognise that risk. But British American has decades of experience dealing with declining demand in some markets, combined with increasing regulation.

It is massively cash generative and its portfolio of premium brands gives it pricing power. Having grown its dividend per share annually for decades, the yield is now 5.2%. That is above the 5% target I mentioned above.

If it can successfully navigate the demand risk facing its industry – for example by increasing its non-cigarette sales – I believe the FTSE 100 company could potentially keep paying big dividends.

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Pair this with a blockbuster dividend and a valuation on the cheap side and you’ve got what I’ve been saying for years — there could be plenty of life in the old dog yet. I suspect British American Tobacco could turn out to be one of those rarest of stocks that offer above average dividends along with big growth in share price.

Icing on the cake

To start with, the price target change was absolutely massive. What was the justification? What did Morgan Stanley like so much?

For one, the defensiveness of the category was highlighted. Tobacco sales tend to be inflation-resistant. The stickiness of the products often means tough economic times are more easily weathered.

A second point was its cash generation. British American Tobacco makes tons of money. And that means large dividends (a 5.67% yield is on offer at the moment) might continue rising in the years ahead.

A third point in the analysis was its undemanding valuation. A price-to-earnings ratio of 12 is well below the FTSE 100 average and compares very favourably with American competitors.

But the icing on the cake, for me, was the mention of the positive progress of non-combustibles. That means vapes and the like. These non-smoking alternatives really may be able to offset a future in which ciggies are even more on the decline.

Is it a buy?

That’s plenty of positives, so it’s likely worth looking at the negatives too. One obvious drawback for potential investors is the ethical dilemma of investing in a ‘sin stock’. Tobacco causes health issues and that’s not something many people will feel comfortable with.

Following on from that, the lowering consumption and possible outright ban of such products has to be considered too. The UK and New Zealand have already made steps to make smoking not long for this world. This could mean the business as a whole has a shelf life.

On the other hand, I think it’s worth pointing out that the demise of cigarettes has been predicted. But many of the businesses in the sector don’t seem to have been worried.

Here’s an interesting factoid. Which of the FTSE 100 companies on the index when it began in 1984 has made the best investment? You guessed it, British American Tobacco.

Perhaps the next 40 years will be more fruitful for the company than the doomsayers predict. I think it’s worth considering.

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There’s no fun retiring if all you do is sit at home all day, counting the pennies. So you need a pretty decent income. Here’s how much, according to the Retirement Living Standards survey:

Those are challenging numbers. Especially since they assume you live either mortgage or rent-free. It becomes easier once you include the State Pension. Let’s take the example of a single person targeting a comfortable retirement, who gets the full new State Pension, now worth £12,547 a year.

How much do you need to retire in ease?

For a comfortable lifestyle – because who doesn’t want to be comfortable? – they’d need a second income stream of £31,353 a year. Right now, a popular choice for long-term investors seeking income is to build a diversified spread of dividend-paying FTSE 100 shares. Now let’s say their portfolio generates an average yield of 5% a year. To hit that income target, they’d need £627,060. Which is a lot of money. But it’s possible to get there by investing little and often in a combination of FTSE growth and income stocks.

This FTSE 100 company has long been a red-hot favourite among ISA investors – British American Tobacco (LSE: BATS). For decades, it’s offered both dividend income and share price growth, in large amounts. Today, it boasts a generous trailing yield of 5.66%. As a further inducement to shareholders, British American Tobacco is also planning a £1.3bn share buyback for the current year.

Can the dividends keep rolling?

The cigarette maker has an impressive track record of increasing dividends every year this millennium, and the shares have been flying too. The British American Tobacco share price is up 31% over the last 12 months, and 52% over five years. Those who reinvested every dividend they received would have got even more than that.

Tobacco stocks aren’t for everyone. I don’t buy them myself. That’s a personal decision. And of course there are risks. Smoking has been falling out of favour in the West for years. British American Tobacco and its rivals are promoting alternatives, such as vaping, but these remain controversial and subject to stiff regulation. Every stock has risks, which is why it’s important to build a balanced portfolio of companies, covering different economic sectors.

I think British American Tobacco looks well worth considering for investors seeking long-term income and growth. And it’s not even the most generous dividend stock on the FTSE 100. It’s possible to bag yields of up to 7% or 8%, boosting your passive income potential and bringing retirement even closer.

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To help try and cover this shortfall, I think it’s worth considering investing in the stock market via a Stocks and Shares ISA. And with a successful stock-picking strategy, I reckon it’s possible to produce a healthy income stream for later in life. Let me explain.

How could an ISA grow?

If someone built an ISA worth £627,040 and then used it to buy a collection of dividend shares paying 5%, it would be sufficient to produce the £31,352 needed every year which, when combined with the State Pension, would help provide a financially comfortable old age.

Admittedly, this is a sizeable investment pot.But someone investing £266.20 a month for 25 years, achieving an annual return of 13.2%, could get very close (£627,032). However, is a return of 13.2% realistic?

Biggest and best?

As the table below shows, the average annual increase in the share prices of the FTSE 100’s five largest companies since May 2021 is 13.2%. I’ve deliberately excluded Rolls-Royce Holdings as its post-pandemic recovery has been nothing short of remarkable and heavily distorts the average.

Had the dividends received been reinvested, the return would have been even higher.

Of course, history might not be repeated but for those who are prepared to take a long-term view, I think the stock market is the best way to try and accumulate significant wealth.

Going up in smoke?

One of the stocks in the table is of particularly interest because, over the past five years, not only has it delivered over 9% annual share price growth but it’s also paid a healthy dividend.

Thanks to its huge margin and strong cash flows, British American Tobacco (LSE:BATS) is presently (3 May) yielding an impressive 5.7%.

This would produce an annual income of £35,741 on an ISA worth £627,032. Of course, it wouldn’t be sensible to own just one stock, especially given that dividends are never guaranteed, but this example highlights the potential returns available from high-yielding UK shares.

Although I’m impressed by British American Tobacco’s dividend history – it’s raised its payout every year for over a quarter of a century – I’m not convinced it will be able to continue doing this.

Traditional cigarettes are slowly on their way out and I doubt whether the new generation of alternatives will be as profitable as their predecessors. The group’s also borrowed heavily to help fund its move away from conventional tobacco products.

I should explain that I’m looking several years ahead here. In 2025, the group reported year-on-year revenue growth of 2.1% (excluding currency movements) and a 0.7% increase in adjusted earnings per share. On this basis, I don’t see any immediate threat to its payout.

But I’m a long-term investor, which is why I believe there are plenty of better income opportunities to consider elsewhere. Indeed, seven of the FTSE 100 members are currently yielding 6% or more. This could be a good starting point for further research.

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Some are new, but one that is old – very old – is buying shares in businesses in the hope of earning dividends.

That can be a way of turning even just a fiver a day into a monthly passive income in the hundreds of pounds.

Here’s how.

Start putting aside money regularly

The same approach could work with more, or even less money. The income earned would be correspondingly different.

But a key element, whatever the amount, is consistency.

Forming a habit of making regular contributions can help set the stage for growing passive income streams.

Choose a suitable investing platform

In the very beginning, that £5 a day could simply be put in a jam jar on the windowsill.

The cash cannot sit there forever, though, if it is supposed to generate dividends. That will take dividend shares – and a way to buy them.

So an early step in this passive income process would be to choose a share-dealing account, Stocks and Shares iSA, or trading app.

Learn what you need to know

Dividends are never guaranteed, even if a company has paid them in the past. Not only that, but buying dividend shares that then fall in value could lead to a capital loss.

So, it is helpful to get to grips with important concepts like the relationship between free cash flow and dividends and share valuation before starting to build a portfolio of dividend shares.

Compound now for future income

It can feel good when the dividends start coming in. But rather than spend them, a smart move initially can actually be to reinvest them.

Doing that allows the portfolio to grow in size faster than it could do with just the £5 a day ongoing contribution.

Compounding that £5 a day at 6% annually for 25 years, the portfolio should be worth over £100k.

At that size, a 6% dividend yield would mean £500 of passive income per month.

Building the portfolio

A key step is choosing the shares to buy.

6% is around double the current FTSE 100 yield. I see it as achievable, but it is important not to chase yield while ignoring risks. A high yield can be a sign that the City sees potential for a dividend cut.

One share I think investors should consider already yields close to 6%, at 5.7%. It also has an enviable track record of annual dividend increases stretching back decades.

That share is FTSE 100 cigarette manufacturer British American Tobacco (LSE: BATS).

Past performance is not necessarily a guide to what to expect, even though the firm aims to keep growing its dividend annually. Falling cigarette sales volumes already mean the company’s revenues are in decline – and that could get worse.

Others may not want to invest in tobacco companies on ethical grounds.

Still, there are a lot of strengths to the company too. It has strong brands, an efficient manufacturing operation, excellent distribution in much of the world, and a proven business model.

It remains a cash flow machine, helping fund billions of pounds of passive income each year, in the form of dividends.

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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.

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By contrast, many people put some money to work for them to earn even more money. So the income is indeed passive – but it requires capital.

Fortunately, that capital requirement can be low. Here is what someone could aim for with just £3 a day.

What ingredients are in this recipe?

Three quid a day might not sound like much, but it is a start.

Earning passive income by building a portfolio of dividend shares relies on three factors. One is having money to invest.

That daily £3 will start to add up. Indeed, one of the things I like about owning dividend shares as a way to earn passive income is that the plan can be tailored to one’s individual financial circumstances.

A second factor is time. The longer an investor saves, the more money there is to invest. That can translate to more passive income.

The third factor is what that money earns. This can be determined by the dividend yield of a portfolio. Yield is basically what is earned in dividends each year, expressed as a percentage of the cost of the shares.

Being a smart investor

Still, that does not mean it is necessarily a good idea simply to chase the highest yield. After all, dividends are never guaranteed. A high yield can be a red flag that the City expects a company to reduce or even cancel its dividend.

That explains why it makes sense both to diversify the portfolio and choose carefully what shares go into it. It also makes sense to try and keep dealing costs and commissions low by selecting a suitable share-dealing account, Stocks and Shares ISA or trading app.

Say someone invests £3 a day for 10 years, reinvesting dividends during that period, before taking them as passive income at the 10 year mark, even without investing another penny. At a 3% yield (what the FTSE 100 currently offers), that should lead to an annual passive income of around £377.

A 5% yield would mean that number was roughly £689. Or, at a 7% yield, £1,059.

One share to consider

I will stick with that 5% yield as one I think is eminently achievable in today’s market while sticking to blue-chip shares.

For investors without ethical objections to tobacco shares, one solid dividend payer I think merits consideration is FTSE 100 member British American Tobacco (LSE: BATS). It has grown its dividend per share annually for decades. The current yield is a juicy 5.8%.

In the past five years, the share price has grown a handy 52%, but despite that, I still think it is reasonable at 12 times earnings.

Declining cigarette consumption is a risk to the firm’s revenues – which have been falling in recent years – and profits. But its premium brand portfolio gives the Lucky Strike owner pricing power to try and mitigate declining sales volumes.

It remains a massive cash generator. That could help support the dividend in future.

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But how much could a £10,000 investment in this consumer-focused company actually generate?

What the numbers tell us

Here’s the maths. Put £10,000 into this stock at the current forward dividend yield of 5.96%, and that’s roughly £596 a year landing in a portfolio.

Hold that for a decade, assuming the yield is held constant, and the cumulative dividend income alone comes to approximately £5,960. That’s before any share price growth and before reinvesting dividends, which could push the total return considerably higher.

I’ve included a bit of a snapshot for investors below:

• Forward dividend yield: 5.96%
• Market cap: £90.7bn
• Price-to-earnings (P/E) ratio: 11.8

Those are compelling for a single FTSE 100 holding. But which stock is behind it and does the income actually stack up?

A high-yielding defensive giant

The stock in question is British American Tobacco (LSE: BATS).

The company has been one of the most reliable income stocks in the Footsie for years. The shares are essentially flat year-to-date yet up over 30% to 4,181p in 12 months, as I write ahead of the weekend.

Given its low double-digit P/E ratio and sizeable market cap, I think this is a business trading at a meaningful discount to the broader market. It’s a controversial sector, of course, and investors need to weigh that against their own beliefs.

But from a pure income perspective, the numbers speak for themselves. Tobacco has historically been one of the most cycle-resilient industries around with consumption historically holding up even when economies wobble.

A 5.96% dividend yield sounds attractive. But is it built to last?

Does the dividend look sustainable?

That’s the key question for mine. The long-term picture for traditional tobacco volumes isn’t pretty. Cigarette consumption is falling in most developed markets as regulation tightens and habits shift, including the recent UK ban for those born after 2008.

However, the company is investing in next-generation products including vaping and heated tobacco. Profitability in those categories is still developing, and the regulatory outlook remains uncertain.

A sharper-than-expected decline in traditional volumes could put the dividend under pressure down the line.

The risks are real but does the yield still make the case for investors to consider buying?

My verdict

For income-focused investors comfortable with the sector, I think the company makes a genuinely interesting case right now.

Diversification is often the key to generating a long-term income, but there is a lot to like about British American Tobacco.

There aren’t many stocks out there boasting a 5.96% forward yield, a P/E ratio just shy of 12, and a dividend history built on resilient cash flows through the economic cycle.

I’d want to see continued momentum in next-generation products before going in heavily, but at current levels it’s well worth a closer look.

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It can actually be a very lucrative one – and one that is widely used. Buying blue-chip shares that pay dividends costs money. But it ticks the key passive income boxes: it is effortless and can generate income.

Here is how that might work for someone targeting £1,000 each month on average in income (I ought to add that it could also work for a higher or lower target, but the sums invested will need to be adjusted accordingly).

Have BP, Tesco, Vodafone and more working for you!

I mentioned blue-chip shares above. Those are large, well-established companies like Tesco, BP and Vodafone. Being big and having a successful past is not necessarily an indicator of how a firm may perform in future. It is still important to look into each individual share being considered, and to diversify the portfolio across a range of companies.

But my point is that this passive income plan is not based on tiny companies few people have heard of. My preference is to stick to proven, blue-chip businesses and let their hard work provide income in the form of dividends.

A four figure monthly income

A target of £1,000 a month in passive income adds up to £12k a year. Currently, the FTSE 100 yields 3.1%. That means it pays roughly £3.10 in dividends annually for each £100 invested.

I think a higher yield is achievable, while sticking to blue-chip shares. Let’s say 6%. At that rate, the ISA would need to be worth £200k to earn the target income of £1k a month.

It’s possible to start with nothing

So someone with a spare £200k in their ISA could get going immediately.

What about someone with an empty ISA or none at all? They could start by choosing the right Stocks and Shares ISA for them, then putting in £20k a year for a decade, drawing dividends along the way.

Or they might try to speed things up, by reinvesting (compounding) the dividends at first. After nine years compounding at 6% annually, the ISA should be worth over £200k, at which point the dividends could be used as passive income.

Here’s a blue-chip share to consider

I mentioned a few blue-chip shares above, but the highest yield in that trio is the 4.2% offered by BP. A higher yield — 5.8% — is offered by British American Tobacco (LSE: BATS). That is still not 6%, but could form part of a portfolio that hits that target.

Not everyone feels ethically comfortably investing in tobacco companies. For those that do, I see British American Tobacco as a share to consider.

It is one of only a few FTSE 100 shares that have grown their dividend per share annually for decades. It plans to keep doing so, but declining cigarette usage is a risk both to revenues and profits. Despite its premium brands pricing power and a non-cigarette business, revenues have fallen for three years on the trot.

But the company still sells large volumes of cigarettes and is massively cash generative. It has long experience of navigating difficult markets — and I believe it can keep doing well.

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