Patience is one of the key attributes of a successful investor. The likes of US master Warren Buffett have been known to wait years for the right company at the right price.
Now, while buying stocks at a fair price will tend to pay off over the long term, we all love to bag a real bargain.
Today, I’m going to tell you the price I think would put FTSE 100 mining giant Rio Tinto (LSE: RIO) (NYSE: RIO.US) in the bargain basement.
Pricing power
Markets generally give companies with ‘pricing power’ a higher earnings rating than those that lack it. As Buffett has said: “You’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business”.
Companies with pricing power include those with powerful brands, such as Buffett favourite The Coca-Cola Company, and UK premium spirits group Diageo. These sorts of companies tend to trade on well-above-average price-to-earnings (P/E) ratios, while companies in industries with poor pricing power are often found at the lower end of the P/E range (except when the industries are booming).
There’s not much that miners can do about pricing. Rio Tinto’s iron ore is little different to the iron ore of any other miner. Iron ore is iron ore. As such, while I would consider Diageo, for example, to be in the bargain basement even at a bit of a premium to the FTSE 100 long-term average P/E of 14, my bargain value for Rio is considerable lower.
At what price a bargain?
My bargain-basement rule of thumb for a megacap company in an industry with poor pricing power is a 12-month forecast P/E of below 10. The forward earnings consensus for Rio is about 300p a share, which means I would be looking for a share price of under 3,000p.
Since Rio’s empire-building chief executive Tom Albanese was sacked in 2013, new boss Sam Walsh has been intent on delivering “greater value for shareholders”, including improving cash flow and dividends. Because of this, I’m comfortable applying dividend yield as a double-check marker of value, as I do for other megacap natural resources companies, such as oil giant Shell.
My bargain-basement rule of thumb on this metric is a 12-month forecast yield of at least a third above the market average. Rio’s forward yield at 3,000p works out at 4.7%, which is pretty much bang on 133% that of the FTSE 100.
My P/E and yield requirements, then, are both telling me Rio would be a bargain buy at a price of up to 3,000p. The shares are not much above that at the time of writing, having closed on Friday at 3,039p.