This Model Suggests Rio Tinto plc Could Deliver A 10.9% Annual Return

Roland Head explains why Rio Tinto plc (LON:RIO) could deliver a 10.9% annual return over the next few years.

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One of the risks of being an income investor is that you can be seduced by attractive yields, which are sometimes a symptom of a declining business or a falling share price.

Take Rio Tinto (LSE: RIO) (NYSE: RIO.US), for example. This giant miner’s 3.4% prospective yield is slightly above the FTSE 100 average of 3.2%, but it is substantially less than the long-term average annual total return from UK equities, which is about 8%.

Total return is made up of dividend yield and share price growth combined — but Rio’s share price has lagged the FTSE, and is down by 11.6% so far this year, compared to an 11.6% gain for the index. Can Rio recover this lost ground, and deliver an above-average total return?

Should you invest £1,000 in Rio Tinto right now?

When investing expert Mark Rogers has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for nearly a decade has provided thousands of paying members with top stock recommendations from the UK and US markets. And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if Rio Tinto made the list?

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What will Rio Tinto’s total return be?

Looking ahead, I need to know the expected total return from my Rio Tinto shares, so that I can compare them to my benchmark, a FTSE 100 tracker.

The dividend discount model is a technique that’s widely used to value dividend-paying shares. A variation of this model also allows you to calculate the expected rate of return on a dividend-paying share:

Total return = (Prospective dividend ÷ current share price) + expected dividend growth rate

Here’s how this formula looks for Rio Tinto:

(1.12 ÷ 32.48) + 0.075 = 0.109 x 100 = 10.9%

My model suggests that Rio shares could deliver a total return of 10.9% per year over the next few years, outperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.

Isn’t this too simple?

One limitation of this formula is that it doesn’t tell you whether a company can afford to keep paying and growing its dividend.

My preferred measure of dividend affordability is free cash flow — the operating cash flow that’s left after capital expenditure, tax costs and interest payments.

Free cash flow = operating cash flow – tax – capital expenditure – net interest

Rio’s free cash flow was -£8.4bn last year, thanks to a hefty investment programme and a big fall in income. However, I don’t think this is a major cause for concern as previous years show strong free cash flow cover for the firm’s dividend, and Rio’s gearing remains a relatively modest 48.9%, despite increases in net debt over the past three years.

But here’s another bargain investment that looks absurdly dirt-cheap:

Like buying £1 for 31p

This seems ridiculous, but we almost never see shares looking this cheap. Yet this Share Advisor pick has a price/book ratio of 0.31. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 31p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 10%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

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.

> Roland owns shares in Rio Tinto.

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