A 7.7% yield but down 18%! This FTSE gem looks cheap to me

This high-yielding FTSE heavyweight already looks good value and could surge if China’s economic recovery continues.

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FTSE 100 mining giant Rio Tinto (LSE: RIO) is essentially a play on China’s economic growth prospects, in my view.

The Asian Tiger economy has been the key global buyer of many commodities since the mid-1990s to power this growth. In turn, it catalysed a commodities supercycle characterised by broadly rising prices for around two decades.

But with the onset of Covid at the end of 2019, this previously bullish outlook has become less clear. And so has the future of the companies that mine these materials.

Cautious optimism on China

October 18 saw figures released showing China’s economy grew by 4.9% year on year in Q3. This beat market forecasts of 4.4%, affording grounds for optimism that it will meet its official annual growth target of “around 5%”.

Q2 figures showed economic growth of 0.8% on a seasonally adjusted basis, again higher than market forecasts (for a 0.5% increase). On a year-on-year basis, China’s economy grew 6.3% in Q2 — significantly better than the 4.5% rise in Q1. 

On October 20, China’s central bank effectively injected the equivalent of around $100bn into the economy to spur growth. It approved another $137bn in new bonds to be issued, again to help boost growth.

Analysts’ estimates are now that China will achieve its official 2023 economic growth target. Many also believe similar measures in 2024 will continue to push growth, including in the industrial sector.

This, added to ongoing consumer sector growth, should stimulate commodity price gains. And this should support Rio Tinto’s business.

The big risk in the shares is clearly that China’s economic rebound fails. Another risk is a broader decline in global commodity prices if demand from elsewhere declines.

Encouraging Q3 production figures

The company’s Q3 production numbers showed positive trends for its key exports to China.

There was a 1.2% rise in shipments of iron ore – crucial for the country’s vast steelmaking needs. Around 54% of the company’s projected revenue this year will come from this raw material.

Production of mined copper – critical for wiring and as a conduit in China’s renewable power generation – was up 5%. And aluminium production – used in electric vehicles and in China’s huge solar energy sector – was 9% higher over the period.

Is it undervalued?

Rio Tinto does not appear undervalued to its peers on either a price-to-earnings or price-to-book basis. However, it does look significantly undervalued using the discounted cash flow (DCF) method.

Given the assumptions involved, I factored in several analysts’ DCF valuations as well as my figures.

The core assessments for the company are now showing it to 36-68% undervalued. The lowest of these would give a fair value per share of about £81.65, compared to the current £52.26.

There is no guarantee that the stock will reach that point. But it does indicate to me that it may offer good value.

Additionally positive for me is the current yield of 7.7%. This is based on last year’s total dividend of $4.92 at the current exchange rate, and the present share price.

I already have other holdings that give me exposure to the commodities sector. But if I did not, I would buy Rio Tinto today for possible share price gains and healthy yields.

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.

Simon Watkins has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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