British American Tobacco (LSE: BATS) (NYSE: BTI.US) is a company that splits opinion.
Certainly, I’m conscious of the fact that it is not a favourite among ethical investors, and the reasons for this are clear. However, from a purely investment perspective, British American Tobacco continues to deliver excellent returns for its shareholders.
Indeed, return on equity in its most recent full-year was a highly impressive 53%, showing that while tobacco is viewed as unethical by many investors it remains a highly profitable business.
Furthermore, return on equity has averaged 40% over the last five years and has never dipped below 32%. This is extremely encouraging and shows that the company remains highly profitable even during recessions, with such a consistent figure being highly unusual — even for a defensive stock such as British American Tobacco.
So, I’m highly optimistic about the potential for high profits no matter what the next few years have in store for the global economy.
However, a high and consistent return on equity is not the only reason why I’m thinking of investing in British American Tobacco.
Indeed, the company’s interest coverage ratio remains high and shows that even if operating profits were to dip, it has sufficient headroom to continue to service the interest on its debt.
Interest cover last year was a very comfortable 10, meaning British American Tobacco could have paid the interest on its debt 10 times. This is highly encouraging because it means that should there be unforeseen costs or issues with its supply chain that cause operating profit to fall, it is still able to function as a business and recover over the medium to long term.
Furthermore, the current valuation of British American Tobacco looks rather cheap to me. As a mature company operating in a mature industry, its cash flow is strong and the free cash flow yield of 6.1% highlights the attractive price at which shares are currently trading.
Indeed, few companies can offer such a high yield as well as the consistency with which British American Tobacco generates a strong cash flow.
So, I’m highly impressed by British American Tobacco’s return on equity, both in terms of its absolute value and the consistency it offers. In addition, its free cash flow yield indicates that shares offer good value, while the comfortable interest cover shows that the company is likely to come out the other end of challenging future trading conditions.