Regardless of an 8.3% yield, I wouldn't contact this well-liked passive earnings inventory with a bargepole!

In some respects, British American Tobacco (LSE:BATS) might be thought of the proper passive earnings inventory.

It’s presently (30 August) yielding 8.3%, effectively above the common for the FTSE 100 of three.8%.

And for 1 / 4 of a century, it’s elevated its payout year-on-year. This implies it qualifies as a Dividend Aristocrat.

Nonetheless, regardless of being an aesthetic inventory, I wouldn’t contact it with a bargepole.

Let me clarify.

A money machine

British American Tobacco has been capable of pay beneficiant dividends due to its capability to generate masses of cash. Promoting a cheap-to-make, highly-addictive product is a method of guaranteeing a wholesome financial institution stability and powerful money flows.

To assist issues additional, conventional cigarettes are straightforward to fabricate and the essential design hasn’t modified for many years. This implies there’s by no means been a must put aside vital quantities of money for product innovation. 

Till now.

A unique future

The tobacco business is in transition.

As conventional cigarettes fall out of trend, firms are inserting a better emphasis on vapes and different so-called diminished danger merchandise (RRPs). British American Tobacco envisages a smokeless world with 50% of its income coming from RRPs, by 2035.

However this requires vital funding. These New Class merchandise are costlier to make and are prone to require continuous innovation and growth to maintain them related.

And there’s an extended option to go earlier than they replicate the monetary success of cigarettes. For the six months to 30 June 2024, the smokeless vary contributed 17.6% of income however solely 2.3% of working revenue.

For that reason, I think BAT’s standing as a Dividend Aristocrat just isn’t going to final. Having stated that, the decline in conventional cigarette gross sales might be sluggish so I don’t suppose there’s any imminent menace to the payout.  

However there are growing considerations in regards to the security of RRPs. The World Well being Group says that vapes at the moment are banned in 34 nations, together with India and Brazil.

These restrictions may result in elevated income from non-combustible merchandise failing to compensate for the lack of earnings attributable to declining conventional gross sales. If this occurs, I’d be very assured that each the corporate’s share value and dividend will fall.

And naturally, many moral buyers don’t need something to do with the business. This implies there’s an estimated 20% of funds that can by no means spend money on the corporate.

Good worth?

If I didn’t have these considerations, I’d be tempted by the low valuation of the inventory.

For the 12 months ending 31 December 2024, analysts are forecasting earnings per share of 359.7p. This suggests a ahead price-to-earnings ratio of seven.9. That’s low-cost for a FTSE 100 inventory that’s yielding greater than twice the index common.

And that is in step with its closest rival.

Imperial Manufacturers, the opposite tobacco firm within the Footsie, is presently buying and selling on a ahead earnings a number of of seven.3.

Its yield is 7.2%.

This tells me that different buyers have related considerations in regards to the long-term viability of the business.

Shareholders are demanding beneficiant ranges of passive earnings to compensate for the perceived further danger related to having these shares of their portfolios.

Even with a yield of 8.3%, I’m not tempted to spend money on British American Tobacco. It’s simply too dangerous for me.

I feel my cash would go up in smoke.