As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Rio Tinto's (NYSE:RIO) case, we think the firm is undervalued. We think it is fairly valued at $86 per share, significantly higher than where it is currently trading. Our report on Rio Tinto and hundreds of other companies can be found here.
For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for more info on our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Rio Tinto posts a VBI score of 9 on our scale, reflecting our 'undervalued' DCF assessment of the company, its attractive relative valuation versus peers, and bullish techinicals. Rio Tinto ranks far and above its peers on this measure: BHP Billiton (NYSE:BHP), Freeport McMoRan (NYSE:FCX), Cliffs Natural Resource (NYSE:CLF), and Vulcan Materials (VMC).
Our Report on Rio Tinto
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Rio Tinto earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 23.9% during the past three years.
Rio Tinto's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple
and PEG ratio also look attractive versus peers. We are considering adding it to the market-beating portfolio of our Best Ideas Newsletter.
Rio Tinto has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 22.1% in coming years. Total debt-to-EBITDA was 0.8 last year, while debt-to-book capitalization stood at 29.3%.
The firm sports a very nice dividend yield of 3.2%. We expect the firm to pay out about 21% of next year's earnings to shareholders as dividends.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Rio Tinto's 3-year historical return on invested capital (without goodwill) is 23.9%, which is above the estimate of its cost of capital of 10.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Rio Tinto's free cash flow margin has averaged about 19.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from
enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Rio Tinto, cash flow from operations increased about 201% from levels registered two years ago, while capital expenditures expanded about 129% over the same time period.
Our discounted cash flow model indicates that Rio Tinto's shares are worth between $65 and $108 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $86 per share represents a price-to-earnings (P/E) ratio of about 24.4 times last year's earnings and an implied EV/EBITDA multiple of about 6.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 17.4%. Our model reflects a 5-year projected average operating margin of 41.1%, which is above Rio Tinto's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.9% for the next 15 years and 3% in perpetuity. For Rio Tinto, we use a 10.4% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $86 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Rio Tinto. We think the firm is attractive below $65 per share (the green line), but quite expensive above $108 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Rio Tinto's fair value at this point in time to be about $86 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below right compares the firm's current share price with the path of Rio Tinto's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $110 per share in Year 3 represents our existing fair value per share of $86 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.