FTSE 100 commodity giant Rio Tinto (LSE: RIO) is down 13% from its 20 May 12-month traded high of £58.51. I already own shares in the firm but am considering buying more based on the ongoing energy transition.
I believe the shift to net-zero emissions may take longer than many think. But the move looks to have developed an unstoppable momentum, which I believe is a good thing. And without wishing to be mercenary about something so important — if I can make a profit from this, all the better.
What’s the investment rationale?
Wind, solar, water, and geothermal clean energy sources require huge quantities of metals to be turned into power.
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For example, a single offshore wind farm requires six times more steel per megawatt of power generated than traditional thermal coal plants, according to HSBC. Copper and lithium are also used extensively in each of these clean energy sectors.
The International Energy Agency estimates that to achieve net-zero emissions by 2050, the world will need to triple its renewable energy capacity by 2030.
This indicates to me that a dramatic scaling up in the production of these key commodities is on the cards.
Where does this firm fit in?
Rio Tinto targets significant output increases in iron ore (used in steel), copper and lithium in the coming years.
Specifically, it aims to increase its iron ore production by 5m tons annually to the end of 2025. Currently, it is around an average of 323m-328m tons a year.
It also targets a rise in its annual copper output by the same point to 780,000-850,000 tons from 660,000-720,000 tons. By 2030, it targets 1,000,000 tons a year of production.
And the firm now controls the world’s largest lithium resource base following its 9 October $6.7bn purchase of Arcadium Lithium.
How undervalued are the shares?
This deal – and its huge presence in iron ore and copper – makes Rio Tinto a global leader in energy transition commodities.
A risk in the stock is that the energy transition significantly slows for some reason. This would delay the benefits of the investments it has made to that end.
However, analysts forecast it will generate a return on equity of 16.8% by the end of 2027.
The key question for me now is whether the shares look undervalued as well.
On the price-to-earnings ratio of stock valuation, they trade at just 9.1 compared to a competitor average of 18.1. So they look very cheap on this basis.
The same is true of its 1.8 price-to-book ratio valuation against its peer group’s average of 2.7. This is also the case on the price-to-sales ratio, where it trades at 1.8 compared to a 2.1 competitor average.
A discounted cash flow analysis shows the stock is 30% undervalued at its present £50.95 price. So its fair value is technically £72.79, although market unpredictability may push it lower or higher.
Will I buy more shares?
Given its presence in energy transition commodities and its undervaluation, I think it is at least one of the best stocks in the sector.
It also offers a high yield of 6.7% right now, compared to the FTSE 100 average return of just 3.6%.
Consequently, I will be buying more shares in the firm very shortly.
