Is this 7%-yielding overlooked FTSE 100 gem also very undervalued?

This commodities giant posted strong H1 results, has excellent prospects as China continues its economic recovery, and also offers a high yield.

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Sixty percent of the revenue of FTSE 100 commodity giant Rio Tinto (LSE: RIO) comes from China.

The size of the country’s economy is currently $17.8trn. The size of the economy of the present darling of the developing markets – India – is $3.55trn.

This means that even annual growth of 5% a year would mean China adding an economy the size of India’s to its own every four years.

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Last year, China’s economy grew by 5.2% against an official target of “around 5%“. The same target remains in place this year, and I think it will surpass it again.

Poised to benefit from Beijing’s bounce-back

A slowdown in China’s economic rebound after its disastrous Covid years is the primary risk for Rio Tinto, in my view.

However, it recently finalised construction of the Oyu Tolgoi mine in nearby Mongolia. This is destined to become the world’s fourth-largest copper mine, with the copper concentrate currently all going to China.

Copper and aluminium (which Rio Tinto also produces) are also vital to China’s rapid expansion in energy transition products.

The firm is additionally now developing a huge iron ore mine in Western Australia with the China Baowu Steel Group. The country remains the world’s largest steel producer, the key raw material for which is iron ore.

How were the latest results?

The company’s H1 2024 results released on 31 July showed profit after tax rose 14% compared to H1 2023 to $5.8bn.

Free cash flow was down 25%, reflecting the company’s China investments and others.

Underlying EBITDA was up 3% to $12.1bn, and net cash generated from operating activities rose 1% to $7.1bn.

Its strong balance sheet enabled it to pay back 50% of its profit in dividends, as is its practice. This meant an overall payment of $2.9bn for an interim dividend of 177 cents (137p) a share.

Major passive income generator

In 2023, the firm paid a total dividend of $4.35 a share. On the current share price of £47.32, this gives a yield of 7.2%.

By comparison, the FTSE 100’s average yield is presently 3.7%.

So, £10,000 invested in Rio Tinto shares now would give a dividend payout of £720 this year. Provided the rate averaged the same this would rise to £7,200 after 10 years and to £21,600 after 30 years.

However, if the dividends were used to buy more Rio Tinto shares the returns could be much bigger.

Doing this (‘dividend compounding’) would generate an extra £10,500 instead of £7,200 after 10 years. After 30 years, an additional £76,154 would have been made in dividends rather than £21,600!

The total investment of £86,154 would pay £6,203 each year in dividends!

Bargain price as well?

Better still from my perspective is that the shares trade on the key price-to-earnings ratio (P/E) of stock valuation at just 9.4. This is bottom of its competitor group, which averages 21.4.

A discounted cash flow analysis using other analysts’ figures and my own shows the stock to be 34% undervalued.

So a fair price for the shares would be £71.70, although they may go lower or higher than that, of course.

Given this heavy undervaluation, its strong push to capitalise on China’s growth, and its high yield, I will be buying the stock very soon.

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Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Simon Watkins has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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