FTSE 100 commodity giant Rio Tinto (LSE: RIO) paid a total divided in 2023 of $4.35. On the current exchange rate, this equates to £3.31, which gives a yield of 7% on the £47.53 share price.
So, investing the average amount of UK savings (£11,000) in the shares would give £770 in dividends in the first year.
Over 10 years on the same average yield, the payout would be £7,700 and over 30 years £23,100.
This is a lot better than could be had from regular UK savings accounts right now. But it is just a fraction of what could be had using the standard market practice of ‘dividend compounding’.
Turbo-charging the returns
All this involves is using the dividends paid to buy more of the shares that paid them. It is a similar idea to leaving interest paid in a savings account where it is to accumulate over time.
In Rio Tinto’s case, this would lead to £11,106 in dividend payouts after 10 years, not £7,700. And the payouts after 30 years would be £78,281 rather than £23,100!
Adding in the initial £11,000 investment, the total Rio Tinto holding would then be worth £89,281. On the same 7% yield, this would pay £6,250 in annual dividends at that point, or £521 each month.
Are the shares undervalued?
China accounts for around 60% of Rio Tinto’s revenue, so the firm’s major risk is that the economy slows. Another risk is that commodity demand from elsewhere falls, pulling commodity prices down for an extended period.
However, I think much of this pessimism related to the firm is already factored into its share price.
On the key price-to-earnings ratio (P/E) of stock valuation, it trades at just 9. This is bottom of its competitor group, which averages 25.3.
A discounted cash flow analysis shows the stock to be 37% undervalued right now. So a fair price for the shares would be £75.44, although they may go lower or higher, of course.
My course of action
I bought the shares very recently at a price I am happy with. So I will not be adding to my holding right now.
That said, the firm is also on my watchlist of high-yield holdings that still look very undervalued to me. Every quarter I thoroughly re-examine their fundamentals and if they align optimally for my purposes I buy more.
As it stands, if I did not already own the stock, I would buy it now for three reasons.
First, it has a much higher yield than the present FTSE 100 average of 3.6%. It is also much better than the ‘risk-free rate’ (the 10-year UK government bond yield) of around 4%.
Second, on several key relative valuation measures I use, it looks very underpriced to me.
And third, I think China’s economy will continue to grow robustly. Last year, it expanded 5.2% and its target this year is “around 5%”.
