Most investors agree that the huge scale and low costs of Rio Tinto (LSE: RIO) iron ore mines mean that they are almost guaranteed to remain profitable. What’s less obvious is how to value the FTSE 100’s eighteenth-largest company.
Rio shares currently trade on about 18 times 2016 forecast earnings, and about 12 times 2015 underlying earnings. The forecast dividend yield for this year is 4.1%. In the short term, I’d argue that this valuation is probably about right. However, I think investors with a longer view could enjoy further gains.
Firstly, Rio is targeting a further $1bn of cost savings in both 2016 and 2017. Even if commodity prices stay flat, this should help to increase the group’s cash flow and profit margins.
A second consideration is that Rio isn’t just about iron ore. I believe the firm’s growing copper operations are likely to be an important source of long-term growth. A final attraction is that Rio is currently using some of its surplus cash to repay debt. This should reduce financing costs and strengthen the balance sheet.
Is this quality stock too expensive?
FTSE 100 gold miner Randgold Resources (LSE: RRS) is without doubt a high quality business. But is it too expensive?
Randgold’s share price has risen by 56% to 6,460p so far this year. The company’s shares now trade on 32 times 2016 forecast earnings. The dividend yield is less than 1%, and Randgold’s £5.9bn market cap means that the firm is valued at 2.5 times its book price.
It’s too much for me. Although the firm’s total cash cost of $648 per ounce means that it can generate plenty of free cash flow at current gold prices, it’s worth noting that profitability has fallen steadily since 2011.
Five years ago, Randgold generated an operating margin of more than 40%, and a return on capital employed of 21%. Those figures have since fallen to 22.2% and 6.3%. This is probably due to a combination of the gold market crash and the group’s continual expansion.
The upshot is that Randgold’s earnings per share are only expected to rise by 15% in 2017. That’s not enough to persuade me to pay 28 times 2017 forecast earnings to invest, so Randgold remains a hold for me.
The ultimate income buy?
One stock that has defied gravity in recent years is National Grid (LSE: NG). Over the last five years, National Grid’s share price has risen by 65%, compared to a 7% increase for the FTSE 100.
Despite these gains, National Grid shares still offer an above-average dividend yield of 4.5%. However, it’s worth noting that growth could be limited over the next few years. National Grid’s earnings per share and dividend are currently expected to rise by about 2% per year in both 2016 and 2017. That may not be enough to drive the shares back above their all-time high of 1,015p.
However, this situation could soon change. National Grid plans to sell its UK gas distribution business to realise value for shareholders and fund new growth. The sale is expected to net National Grid billions of pounds. The company has indicated that much of this would be likely to be returned to shareholders.