Just like peer BHP Billiton, mega-miner Rio Tinto‘s (LSE: RIO) (NYSE: RIO.US) shares have seriously underperformed the market this year. Year to date Rio’s shares have fallen by around 12.7%, underperforming the FTSE 100 by as much as 10%.
However, the company’s shares could fall further from currently levels, as by historic standards, Rio’s shares are still expensive.
Expensive shares
Over the past 10 years, Rio has traded at an average forward P/E of around 8.3, although at present levels Rio is trading at a forward P/E of 9.4.
Based on current commodity prices and barring any unforeseen surprises, City analysts expect the company to report earnings per share of 312.2p next year. Applying a multiple of 8.3 to this figure gives a price of 2,591p. This indicates that the company’s shares could fall 12% from current levels before returning to an average valuation.
Still, there’s a chance that Rio’s shareholders could be richly rewarded if the company’s shares continue to fall.
Takeover speculation
It emerged last month that mining giant Glencore was looking at making a bid for Rio. Glencore currently has no exposure to the iron ore industry and wants to change this. Many analysts believe that the company will acquire Rio in order to meet this goal.
However, Rio is the larger company with a market capitalisation of £58bn, compared to Glencore’s £42bn, but just like it did with Xstrata, Glencore is likely to use its stock as currency if a deal goes ahead. If Rio’s market value continues to fall, the company will become an even more attractive target.
And for shareholders a deal between the mining giants would be great news. If a deal does go through, it’s estimated that Glencore could free up a staggering $49bn in cash from the balance sheets of the combined entities, indicating that shareholders would be richly rewarded.
Falling valuation
Nevertheless, while Rio could find a saviour in Glencore, for the time being the company is still reliant on the price of iron ore to drive profits.
As the price of iron ore has already fallen more than 40% from its high reached last year, Rio is suffering. Indeed, City analysts estimate that a $1 fall in the price of iron ore pulls $122m of potential profit away from Rio. In dollar terms, the price of iron ore has already fallen around $40 per ton since this time last year. Using these figures I estimate that Rio has already seen $4.9bn of potential profit wiped out.
Unfortunately, there’s a chance that the price of iron ore could fall even further as Rio and BHP ramp up low cost production. The two miners are increasing production despite the fact that the market is already oversupplied. This is a thinly veiled attempt to drive high cost producers out of the market.
What’s more, the Chinese construction sector is slowing, reducing demand for the key steel making commodity.
The bottom line
So overall, there’s a chance that Rio’s shares could fall a further 12% from present levels. However, the further the company’s shares fall, the more attractive Rio will become to its possible suitor, Glencore.
Still, even though Rio’s shares could fall further, investors will be pay to wait for a recovery. The company currently supports a dividend yield of 4.1% and the payout is covered three times by earnings per share.
