Even though Reynolds American Inc. (RAI) has risen substantially off of its lows in 2009, the company looks reasonably valued at today's quotations. Therefore, the dividend growth investor looking for above-average dividend yield with moderate growth might want to look closer. The company claims to be transforming the tobacco industry, and maybe it can transform your income portfolio as well.

Dividend Challenger: Reynolds American Inc.

This article looks at Reynolds American Inc., a Dividend Challenger, through the lens of the F.A.S.T. Graphs™, Fundamentals Analyzer Software Tool. Since a picture is worth a thousand words, the reader will be provided the "essential fundamentals at a glance" expressed vividly in pictures.

A Dividend Challenger is defined as a company that has increased its dividend every year for 5-9 straight years. Reynolds American Inc. is a Dividend Challenger that has raised its dividend every year for 8 consecutive years. The complete Dividend Challengers list is compiled courtesy of David Fish. (Open as an excel spreadsheet and look at the tabs on the bottom to find the Dividend Challengers list).

About Reynolds American Inc.: from their website

"R.J. Reynolds Tobacco Company, an indirect subsidiary of Reynolds American Inc. (NYSE: RAI), is the second-largest tobacco company in the United States, manufacturing about one of every three cigarettes sold in the country. The company's brands include many of the best-selling U.S. cigarette brands: Camel, Pall Mall, Winston, Kool, Doral and Salem."

Reynolds American Inc.: A Dividend Challenger with 8 Consecutive Years of Dividend Increases

Learning from the Past - Looking at Earnings Only

Since dividends are paid out of earnings, a clear perspective of a company's historical earnings growth record is a vital component of a dividend investor's prudent due diligence process. The following graph plots Reynolds American Inc.'s earnings per share since 1999 . A quick glance to the right of the graph shows that Reynolds American Inc. has increased earnings at a compounded rate of 8.5% (see purple circle on graph) per annum .

Earnings Determine Market Price and Dividend Income: The following earnings and price correlated F.A.S.T. Graphs™ clearly illustrates the importance of earnings to both price movement and dividend income. The earnings growth rate line or True Worth ™ line (orange line with white triangles) is correlated with the historical stock price line. On graph after graph the lines will move in tandem. If the stock price strays away from the earnings line (over or under), inevitably it will come back to earnings.

Since dividends are paid out of earnings, and therefore represent additional return on top of what the market capitalizes earnings at, they are depicted by the light blue shaded area and stacked on top of the earnings line. Therefore, a quick visual of these two important components is simultaneously revealed:

1. The additional return that dividend paying stocks provide.

2. The percentage of earnings paid to shareholders as dividends (payout ratio).

The value in this article is through carefully analyzing the earnings and price correlated fundamentally based graphs. Notice that one glance tells you how well the company has performed on an operating basis historically and how the market valued that historical performance. Therefore, the reader is free to discover whether or not current valuations make sense based on historical norms coupled with fundamental values. Instead of opinion, this article is designed to produce facts that can be analyzed to the readers investing benefit.

Performance Table: Capital Appreciation and Dividend Income Reynolds American Inc.

The associated performance results, with the earnings and price correlated graph, validates the above discussion regarding the two components of total return: Capital appreciation and dividend income. Dividends are included in the total return calculation and are assumed paid, but not reinvested.

When presented separately like this, the additional rate of return a dividend paying stock produces for shareholders becomes undeniably evident. In addition to the 13.6% capital appreciation (Closing Annualized ROR), long-term shareholders of Reynolds American Inc. would have received an additional $204,827.11 in dividends that increased their total return from 13.6% to 16.5% per annum.

(Note: Since this is a Dividend Challenger it has raised its dividend every year for at least 5-9 years, therefore, negative dividend growth rates shown, if any, will be attributed to special additional dividends paid in excess of the company's regularly reported dividend rate)

The following graph plots the historically normal PE ratio (the dark blue line) correlated with 10-year Treasury note interest. Notice that the current price earnings ratio on this quality company is as normal as it has been since 1999.

A further indication of valuation can be seen by examining a company's current price to sales ratio relative to its historical price to sales ratio. The current price to sales ratio for Reynolds American Inc. is 2.77, which is historically high.

Looking to the Future

Extensive research has provided a preponderance of conclusive evidence that future long-term returns, and the dividend and its growth rate are a function of two critical determinants:

1. The rate of change (growth rate) of the company's earnings

2. The price or valuation you pay to buy those earnings

Therefore, forecasting future earnings growth, bought at sound valuations, is the key to safe, sound, and profitable performance.

Therefore, it logically follows that measuring performance without simultaneously measuring valuation is a job half done. At its current price, which is attractively aligned with its True Worth™ valuation, Reynolds American Inc. represents a potential opportunity to invest in a Dividend Challenger at a reasonable price. The important factor is that Reynolds American Inc. has real assets and cash flow underpinning its stock price. This solid economic foundation offers shareholders the potential for both a strong margin of safety and an opportunity for an increasing dividend income stream and potentially attractive future returns.

The Estimated Earnings and Return Calculator Tool is a simple yet powerful resource that empowers the user to calculate and run various investing scenarios that generate precise rate of return potentialities. Thinking the investment through to its logical conclusion is an important component towards making sound and prudent commonsense investing decisions.

The consensus of 14 leading analysts reporting to Capital IQ forecast Reynolds American Inc. long-term earnings growth at 6.7%. Reynolds American Inc. has medium long-term debt at 34% of capital. Reynolds American Inc. is currently trading at a P/E of 15.4, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Reynolds American Inc.'s True Worth valuation would be $61.12 at the end of 2017, which would be a 61.12% annual rate of return from the current price, including assumed dividends.

Earnings Yield Estimates

Discounted Future Cash Flows: All companies derive their value from the future cash flows (earnings) they are capable of generating for their stakeholders over time. Therefore, because Earnings Determine Market Price and dividend income in the long run, we expect the future earnings of a company to justify the price we pay.

Since all investments potentially compete with all other investments, it is useful to compare investing in any prospective company to that of a comparable investment in low risk Treasury bonds. Comparing an investment in Reynolds American Inc. to an equal investment in 10-year Treasury bonds illustrates that Reynolds American Inc.'s expected earnings would be 6.6 times that of the 10-Year T-Bond Interest. (See EYE chart below). This is the essence of the importance of proper valuation as a critical investing component.

This report presents essential "fundamentals at a glance" on Dividend Challenger Reynolds American Inc., illustrating the past and present valuation based on earnings achievements as reported. Future forecasts for earnings growth are based on the consensus of leading analysts. Although with just a quick glance you can know a lot about the company, it's imperative that the reader conduct his or her own due diligence in order to validate whether the consensus estimates seem reasonable or not. Follow the link we provided at the beginning of this article to a fully functioning F.A.S.T. Graphs™ on Reynolds American Inc.

Summary & Conclusions

Reynolds American Inc. might be a Goldilocks portfolio opportunity. At its current share price, it appears to be neither too hot nor too cold. In other words, regarding valuation, Reynolds American Inc. seems to be just right. The main attraction here is a strong dividend yield with the opportunity to grow over time. As always, we recommend you conduct your own thorough due diligence.

Disclosure: No position at the time of writing.