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

In some respects, British American Tobacco (LSE:BATS) may very well be thought of the right passive earnings inventory.

It’s at present (30 August) yielding 8.3%, properly 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.

Nevertheless, regardless of being a cultured 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 lots of money. Promoting a cheap-to-make, highly-addictive product is a method of guaranteeing a wholesome financial institution steadiness and robust money flows.

To assist issues additional, conventional cigarettes are simple to fabricate and the fundamental 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 trade is in transition.

As conventional cigarettes fall out of trend, corporations are putting a better emphasis on vapes and different so-called decreased 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 improvement to maintain them related.

And there’s an extended method 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 believe BAT’s standing as a Dividend Aristocrat will not be going to final. Having stated that, the decline in conventional cigarette gross sales shall be gradual so I don’t assume there’s any imminent menace to the payout.  

However there are rising considerations concerning the security of RRPs. The World Well being Group says that vapes are actually banned in 34 international locations, together with India and Brazil.

These restrictions may result in elevated income from non-combustible merchandise failing to compensate for the lack of earnings as a consequence of 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 trade. 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 consistent with its closest rival.

Imperial Manufacturers, the opposite tobacco firm within the Footsie, is at present 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 concerning the long-term viability of the trade.

Shareholders are demanding beneficiant ranges of passive earnings to compensate for the perceived extra 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.