For investors in Rio Tinto (LSE: RIO), the last year has been exceptionally tough. That’s because the iron ore specialist’s share price has slumped by 30% and has shown little sign of reversing this trend in recent weeks and months. As a result, it may seem somewhat surprising to suggest that the company is set to post exceptional share price gains of over 25% so that its valuation reaches £30 per share.
However, Rio Tinto has huge upside potential. Certainly, it is suffering from an iron ore price that has declined to a ten-year low and, with the company relying on sales of the commodity for the vast majority of its profit, the impact on its earnings has been nothing short of horrific. For example, Rio Tinto is expected to report a 49% fall in its bottom line in the current year, which is reason enough to merit the aforementioned share price fall.
Looking ahead, though, Rio Tinto is positioning itself so that it could be set to benefit from the current difficulties in the iron ore industry. For starters, it has increased production and, while this has contributed somewhat to the falling price as supply exceeds demand by an even greater amount, it also puts additional pressure on smaller, less efficient iron ore miners. And, with Rio Tinto having a size and scale advantage over the majority of its peers, this means that the company should be able to win market share and increase its domination. In the long run, this should equate to higher margins and greater profitability.
Although this year’s results are set to disappoint, Rio Tinto’s net profit is forecast to rise by 9% next year. While this will not recover the lost ground in the current year, it shows that the company has the potential to bounce back following a difficult period. As a result, investor sentiment in Rio Tinto could stabilise and improve ahead of a more encouraging outlook.
However, the real appeal of Rio Tinto is with regard to its income prospects. For example, it currently yields a whopping 6.1% and, with dividends set to rise by 3.2% next year, this is set to reach 6.3% in 2016. As a consequence, buying Rio Tinto now could mean an income return of 12.8% over the next two years. And, with dividends being covered 1.2 times by profit, the current level of shareholder payouts seems to be sustainable given the forecasts for profitability in the short to medium term.
In fact, if Rio Tinto’s share price were to rise by over 25% and trade at £30, it would still offer a dividend yield of over 5% next year. This would keep Rio Tinto among the highest yielding stocks on the FTSE 100 and, as a result, would continue to have upside potential as investors carry on chasing high-yielding shares. Moreover, at £30 per share, Rio Tinto’s price to earnings (P/E) ratio would stand at 16.9 which, for a high quality and dominant mining company, would not be a particularly expensive price to pay.
So, while the past has been disappointing for investors in Rio Tinto, its mix of income potential and capital growth prospects mean that now could be a great time to buy a slice of it.
