Is FTSE 100 Stalwart British American Tobacco a Good Value?

LONDON -- Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If bought when the shares are cheap, two drivers could move the share price up:

• growth in earnings
• an upward P/E rerating

Highly successful fund manager Peter Lynch classified steady growers as Stalwarts, which he typically traded for 20% to 50% share-price gains. But whether buying for gains like that or holding for the longer term, we need to know if reliable earnings growth can continue, and whether the shares are cheap.

Seeking durable growth
Not all companies achieve stable growth, as you can see by the aggregate performance of those in London's premier FTSE 100 (INDEX: ^FTSE) index, where the compound annual earnings-growth rate has been just 0.7% over the last five years:

Consistent, cash flow-backed growth in profits is a promising characteristic in today's markets so, for this series, I'm examining firms with annual earnings growth between 4% and 20%.

One contender is British American Tobacco (BATS -0.55%) (BTI -0.81%), which is a tobacco company founded in 1902 as a joint venture between the U.K.'s Imperial Tobacco Company and the American Tobacco Company. It is second only to Philip Morris in the world's cigarette markets. This table summarizes the firm's recent financial record:

So, earnings have grown at an equivalent 15.9% compound annual growth rate, putting BATS in the Stalwart category.

In a management statement delivered on Oct. 24, BATS directors confirmed the continued steady progress of the company despite the fug of difficult macroeconomic news hanging over us and declining industry volumes.

BATS gets its product to craving consumers via 46 cigarette factories in some 39 countries packaged as any one of 300-plus brands. Around 27% of turnover comes from the Asia-Pacific region, 27% from Eastern Europe, the Middle East and Africa, 23% from the Americas, and 23% from Western Europe.

There has never been a problem with customer retention for the repeat-purchase products that tobacco firms manufacture, although the whole-of-life customer experience shows some signs of attenuation compared to other industries -- burn rates are faster. That's why the firm puts so much effort into smoking out new customers, and has rolled its marketing package up into an irresistible offering that seems to set fire to consumers' desire in both established and emerging markets around the world.

If BATS can keep converting its highly repetitive revenues to earnings, further growth seems likely, and that's sure to light up investors.

British American Tobacco's earnings growth and value score
I analyze five indicators to determine whether earnings growth can continue and if the shares offer good value:

1. Growth: Revenue, earnings and cash flow have all been growing steadily. 5/5
2. Level of debt: At the last count, net gearing stood at around 128%. 3/5
3. Outlook and current trading: Good recent trading and a cautiously positive outlook. 4/5
4. Enterprise value to free cash flow: A trailing 22, and above historic growth rates. 2/5
5. Price to earnings: Trailing at about 17, and around historic growth rates. 3/5

Overall, I score BATS 17 out of 25, which encourages me to believe this stalwart can continue earnings growth that outpaces that of the wider FTSE 100. When compared to the FTSE's price-to-earnings ratio of around 11 and the firm's growth predictions, the shares seem to price in further earnings-growth expectations.

Foolish summary
BATS has a record of steady growth in most important financial indicators and debt seems to be within manageable limits. Steady growth is attractive and the value indicators show that investors have turned their heads here.

Right now, forecast earnings growth is 9% for 2013, and the forward P/E ratio is about 14.5 with the shares at 3,262 pence. Considering that and the other factors analyzed in this article, I think that BATS looks fairly priced by its shares.

British American Tobacco is one of several steady-earnings-growing stalwarts on the London stock exchange, each with the potential to deliver significant capital appreciation when purchased at sensible prices.

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