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This P/E Suggests Rio Tinto plc is a Buy

The FTSE 100 has risen by more than 85% since it hit rock bottom in 2009, and bargains are getting harder to find.

I’m on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I’m using a special version of the price to earnings ratio called the PE10, which is one of my favourite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last ten years. This lets you see whether a company looks cheap compared to its long-term earnings.

Today, I’m going to take a look at the PE10 of mega-miner Rio Tinto (LSE: RIO) (NYSE: RIO.US).

Is Rio Tinto a buy?

Over the last couple of years, a great many column inches have been devoted to ‘the end of the commodities supercycle’. Despite this, demand for iron ore, copper, aluminium and coal — the main commodities produced by Rio Tinto — is not going to stop growing.

Chinese GDP growth looks likely to remain between 5% and 7% per annum, while other emerging markets — such as Latin America — are also investing heavily in infrastructure projects.

I believe Rio is good value at under 3,000p per share, but let’s see how the firm is valued against its recent and historical earnings:

  Trailing
P/E
PE10
Rio Tinto 8.8 13.5

Rio’s PE10 of 13.5 is below the FTSE 100 average of 16.9, but it isn’t very cheap on an absolute basis, especially for a big company whose growth may be slowing.

However, I believe that in Rio’s case, the firm’s trailing P/E is a more accurate indicator of its valuation, for three reasons.

Firstly, the big miners are all cutting back on capital-intensive new projects and are focusing on profitability and shareholder returns. Rio’s Australian iron ore assets are amongst the lowest-cost in the world, and should be a reliable cash cow for the company.

Secondly, Rio is a bigger company than it was ten years ago. Although Rio’s aluminium and coal assets made very little contribution to the firm’s profits last year, this situation won’t last forever. Aluminium, in particular, will eventually recover.

Finally, Rio shares currently offer a prospective yield of 4.1% and trade on a P/E of less than nine. In today’s market, that looks good value to me, and provides a good opportunity for investors to acquire an income stream derived directly from commodities.

Can you beat the market?

If you already own shares in Rio Tinto, then I’d strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top UK fund manager Neil Woodford’s eight largest holdings.

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> Roland owns shares in Rio Tinto.