The Best Tobacco Stock: Altria Group, Inc. (MO), Lorillard Inc. (LO), Reynolds American, Inc. (RAI)

Payout Ratio

The payout ratio is simply the percentage of the free cash flow that is used to pay out dividends. If the payout ratio is low this means that dividend growth can come from both increasing earnings and increasing the payout ratio. Alternatively, if the payout ratio is high, this could mean that dividend growth will slow from historical levels. Let’s compare the payout ratio from 2009-2011 for these three companies. (Since all of the companies haven’t reported full 2012 results yet I don’t have FCF for 2012)

Payout Ratio

Data from Morningstar

Both Altria and Reynolds had a year where they paid out more in dividends then they had in free cash flow. It’s no surprise, then, that these two companies also had the lowest dividend growth rate. Both Philip Morris and Lorillard have reasonable payout ratios.

It appears that Lorillard is the clear winner here. With a 5.23% dividend yield, a 3-year dividend growth rate of 17.34%, and a reasonable payout ratio, Lorillard offers the best of both worlds. In addition, Lorillard has been using its ample free cash flow to aggressively buy-back shares, reducing its share count from 494 million at the end of 2009 to 391 million at the end of Q3 2012. This is a 20% reduction in less than three years. This means that a third of the dividend growth since 2009 has been driven by share buybacks, while the remaining two-thirds has been driven by FCF growth. Even if FCF stays flat from here on out share buybacks alone can drive the dividend per share higher.

Is Lorillard A Value?

Even without doing any sort of calculation its clear that Lorillard is a fantastic dividend stock. The question is: how fast does the dividend need to grow to justify the current share price? To answer this I’ll use the dividend discount model. I’ll assume that after ten years the dividend will grow at a perpetual rate of 3%, and through trial and error find the 10-year growth rate which yields the current stock price. For my discount rate I’ll use 8%, roughly the long-term growth rate of the market as a whole. Here is the result.

Astoundingly, Lorillard only needs to grow its dividend at about 2% annually to justify the current share price. This is about the cheapest dividend stock I’ve ever seen. If the company is able to grow the dividend at 10% annually the fair value jumps to $74 per share.

The Bottom Line

Lorillard is trading at a level which assumes dividend growth will be almost nonexistent going forward. Lorillard sells mainly menthol cigarettes, which are at risk of facing increased regulation from the US government. If this occurs then profitability will certainly suffer. But the stock is so cheap that even an anemic 3% annual increase renders it undervalued. Lorillard offers a fantastic addition to a dividend-focused portfolio.

The article The Best Tobacco Stock originally appeared on Fool.com and is written by Timothy Green.

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