Earning £1,000 a year in passive income is a milestone for any investor. And I think dividend shares are one of the best ways of generating extra cash. 

British American Tobacco (LSE:BATS) shares currently come with a 5.7% dividend yield. That’s much better than savings accounts and this gives investors something to think about. Of course, unlike interest in a savings account, dividends are never guaranteed.

Dividends

British American Tobacco currently returns 60.06p per quarter to investors. At that level, a £1,000-a-year second income requires 416 shares – and an outlay of £17,478 at today’s prices. 

There aren’t many FTSE 100 companies that offer that kind of immediate return for the same outlay. But investors need to keep an eye on the bigger picture. 

The obvious point is that demand for cigarettes has been in decline for some time. British American Tobacco has two main ways of trying to offset this issue.

In the short term, the company has been raising prices. This has been working well, but there will come a time sooner or later when the firm can’t just get more cash from fewer customers.

A more promising long-term strategy is aiming to grow alternate products, such as nicotine pouches. These aren’t in decline, but it’ll be a while until they’re a big enough market to offset cigarette declines.

That’s the equation investors need to weigh up – the risk of a declining core product against strong pricing power and promising new categories. But there’s something else to consider.

Capital allocation

Like a lot of businesses, British American Tobacco returns cash to shareholders through a combination of dividends and share buybacks. But the balance between the two is interesting.

Share buybacks reduce the number of shares outstanding and mean investors come to own more of the firm. But this isn’t much good for a company in terminal decline.

With a business that doesn’t have good long-term prospects, I think it’s better to get as much cash as possible out of the company as quickly as possible. That makes dividends a preferable option, in my opinion.

Buybacks are more effective when a firm has good long-term prospects, especially when the stock is also undervalued. In this case, owning more of the business is valuable for shareholders.

In this context, British American Tobacco’s capital allocation is interesting. The company has spent around five times as much on dividends as buybacks over the last 12 months. 

From an investment perspective, that gives me cause for concern. The firm’s new products might give it some strong long-term prospects, but I don’t think its focus on dividends fits well with this.

Passive income

I don’t have a better idea for turning £17,478 into £1,000 a year in passive income in the next 12 months. Despite this, British American Tobacco shares aren’t on my buy list at the moment.

The firm seems to be focused on returning as much cash to shareholders as quickly as possible. And I think that’s understandable given the challenges the business is facing.

In this context, however, a 5.7% yield isn’t enough to convince me to buy the stock. From a long-term perspective, I think there are better income opportunities elsewhere in the FTSE 100.