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If you had to make a short list of the characteristics that might make a company become overvalued in the short-term, it might be factors such as this: a high starting dividend during a period when ten-year government-issued bonds only yield 3%, a perceived new product that will bring about significant growth, and brands that have performed well against countervailing risks.

In the case of Reynolds American (NYSE:RAI), the conditions for creating an overvaluation have become ripe: there are not a whole lot of places in the investing world where you can get a 5% initial dividend yield with a long track record of annual dividend growth, the Vuse e-cigarette opens the door to future growth down the road, and Reynolds benefits from a uniquely blended portfolio of tobacco products that has historically allowed it to be an all-weather cash cow. That is to say, the Winston and Camel premium brands do the job of creating huge gobs of profits for Reynolds to pay out as dividends and buy back stock, and the Winston, Doral and Pall Mall brands are useful for helping Reynolds retain steady volumes in an industry that typically sees 4% annual declines in tobacco product shipments across the United States.

These are the factors that explain why Reynolds is a good business that is quite good at enriching shareholders over the long-term. But you shouldn't buy something unless the relationship between business quality and valuation intersects favorably, and right now, the valuation is riding a high that the company has not seen in the 1999-2013 period, except for parts of 2003 and 2012.

Each share of Reynolds American is currently producing $2.84 in profits (over the past trailing twelve months) in relation to a share price of just under $50 per share. That works out to a P/E ratio between 17 and 18x earnings. Between 1999 and 2012, the average annual P/E ratio for the stock was between 7x earnings and 15x earnings (2003 was an odd year in which earnings plummeted to $0.39 per share, and is therefore not useful in performing a P/E ratio analysis because the figure has nothing to do with overall earnings power of the company).

Generally, Reynolds trades in the sweet spot of 11-12x earnings. That was where the company traded in 2001, 2004, 2005, 2008, 2010, and large parts of 2007 and 2011. The late 1990s figures are heavily distorted by the fear of excessive litigation costs (when you saw P/E ratios drop to around 7x earnings for Big Tobacco) and the 2009 period of 9x earnings was influenced by the financial crisis. With interest rates so low, we have reached a point where Reynolds' valuation is well above where it has been in the past fifteen years, on a normalized basis.

Those $2.84 in annual profits should be capitalized at a rate around 11-12x earnings if you want to do it right by not incorporating a negative margin of safety (defined as prices when long-term P/E compression is inevitable), and that would imply a share price of between $31.24 and $34.08 per share. To put it in plain English, the price of Reynolds stock needs to fall about 30% to reach a fair price.

Despite these valuation concerns, tobacco companies have a way of being resilient even in the face of overvaluation because they keep growing profits (forcing the estimates of fair value upward) and returning a lot of cash to shareholders, which is an important ingredient in the total returns of tobacco stocks. For instance, the company's quarterly dividend currently sits at $0.63 per share. Even without factoring in future raises, Reynolds shareholders will collect at least $7.56 over the next three years. If profits hit $3.50 three years from now as expected, even if the P/E ratio fell to 12x earnings, you'd still break even because the price of the stock's fair value would increase to $42 per share and you'd collect that $7.56 which would soften the blow of overpaying for the stock. That's been the fun thing about tobacco stock ownership historically: even if you were unwise and overpaid, the profit growth and dividend payouts have usually had a way of protecting you from economic harm as the result of undisciplined investment.

Unfortunately, the company is buying back ten to fifteen million shares of stock each year. Right now, at 17-18x earnings, that does not seem like it is in the best interests of shareholders. If interest rates rise and the valuation experiences a reversion to the mean towards 11-12x earnings a few years from now, shareholders will probably be left wondering why the management team didn't have the discipline to wait for an opportune moment to retire huge chunks of stock.

With the exception of 2003 in which Reynolds' profits were an extreme anomaly, the valuation of Reynolds stock has not been this high in the past generation. A deserved P/E compression will be an eventual headwind for shareholders in the neighborhood of 30%. That does not mean, however, that shareholders will necessarily get whacked. A growing 5% dividend can cover up some of the pain caused by a justified P/E compression, and a couple of years of profit growth can increase the earnings base to justify the valuation at $50 per share. But still, unless a company turns the corner towards very high earnings per share growth, you don't want to get in the habit of paying generational highs for stocks. Even though Reynolds is a great cash-cow business, it's probably best to wait for a healthy price decline before initiating an ownership stake.

Source: Reynolds American: A Cash Cow With A Bloated Valuation