Shares in FTSE 100 metals and mining giant Rio Tinto (LSE: RIO) have dropped 12% from their high this year.
This has been driven by market concerns over China’s economic recovery following three years of Covid. Before that, the country’s dramatic economic growth had powered commodity price gains from the mid-1990s.
I try to buy stocks when they are at or near the bottom of where I think they should be. This is based primarily on business fundamentals and stock valuation methods. I also look at the prospects for dividend payouts, as I expect to be compensated for supporting the stock.
In my view, Rio Tinto looks like it might be at such a turning point. The big risk in the shares, of course, is that China’s economic rebound fails. Another is that demand remains stagnant or drops elsewhere.
Well-positioned core business
Recent economic data points to China achieving its target growth this year of “about 5%”. Several major stimulus measures recently also point to its economic recovery continuing into 2024, in my view. This provides an ideal operating environment for Rio Tinto.
The company’s Q3 production results saw a 1.2% rise in shipments of iron ore — crucial for China’s vast steelmaking needs. Around 54% of the company’s projected revenue this year will come from this raw material.
Production of mined copper — critical for wiring and as a conduit in China’s renewable power generation — was up 5%. And aluminium production — used in its electric vehicles and solar energy sector — was 9% higher than the third quarter of 2022.
Undervalued compared to peers
Rio Tinto is slightly undervalued compared to its peers on a price-to-book (P/B) basis. It currently trades at 2.2, with Anglo American at 1.3, Vale at 1.7, Fortescue at 2.9, and BHP Group at 3.5. This gives a peer group average of 2.4.
However, it is very undervalued on a discounted cash flow (DCF) basis. Given the assumptions involved in this, I use several analysts’ DCF valuations as well as my own.
The core assessments for Rio Tinto show it to be between 56% and 60% undervalued. The lowest of these gives a fair value per share of £127.25, against the current price of £55.99.
Of course, the stock may not reach this price. It does reiterate to me, though, that it looks like very good value indeed.
Big passive income generator
In 2022, Rio Tinto paid a total dividend of $4.92. At today’s exchange rate and share price, this gives a yield of 6.9%. The FTSE 100’s current average payout is around 3.9%.
If the yield averaged the same over 10 years, a £10,000 investment would make me another £6,900 over that time.
This would not include gains from reinvesting the dividends it paid me back into the stock, which I would do. On the other hand, tax liabilities would have to be deducted.
Positively as well, Rio recently reaffirmed its policy of paying 50% of underlying earnings to shareholders.
I have holdings in the sector, but if I did not, I would buy Rio Tinto for the yield opportunity. I also think it is likely that China will recover economically over time and the company’s share price with it.
