In 2024, FTSE 100 miner Rio Tinto (LSE: RIO) paid $4.02 in dividends, fixed at a sterling equivalent of £3.10.
This means a yield of 6.9% on the current £44.95 share price. By comparison, the current average yield on the FTSE 100 is 3.5%.
Average savings in the UK are £11,000, and this invested in the stock would make £759 in first-year dividends.
Over 10 years, on the same average yield (which may not happen, of course), this would increase to £7,590. And after 30 years on the same basis, it would increase to £22,770.
Thirty years is what I see as a standard investment cycle. It starts at around 20 years old and ends at about 50, with potential early retirement.
Using the magic of dividend compounding
That said, much greater dividend returns can be made by using ‘dividend compounding’. This is a standard investment practice involving the dividends paid by a stock being reinvested back into it.
Doing this on the same 6.9% average yield would result in £10,888 being made in dividends, not £7,590. And over 30 years, this would increase to £75,658, rather than £22,770.
By that point, the total value of the Rio Tinto holding would be £86,658. And this would pay £5,979 a year in dividend income!
The benefit of an undervalued share price
A discounted cash flow (DCF) shows the stock is 36% undervalued at its current £44.95 price. Therefore, its fair value is £70.23.
The DCF is a standalone valuation that identifies where any share price should be, based on the underlying business’s fundamentals.
Comparative valuations with its key competitors further confirm this undervaluation. For instance, Rio Tinto’s 9.4 price-to-earnings ratio is bottom of its peer group, which averages 23.2
This group consists of BHP at 11.3, Vedanta at 11.4, Antofagasta at 29.8, and Griffin Mining at 40.5.
Does the business look solid?
The firm is currently transitioning towards lithium and copper to align with the energy transition.
Lithium is a key component in batteries used in electric vehicles, phones, and computers, among other items. It also plays a vital role in the storage of wind and solar power.
Meanwhile, copper is an essential material in solar panels and wind turbines, and for electric vehicles and smart grids.
Rio Tinto’s mixed H1 results reflected this transition phase. A risk here is that this might stall, giving rival firms a competitive advantage.
Net cash generated from operating activities fell by 2% year on year — to $6.924bn (£5.21bn). And over the same period, earnings before interest, taxes, depreciation, and amortisation dropped 5% to $11.547bn.
That said, I tend to agree with CEO Jakob Stausholm’s comment that: “We remain on track to deliver strong mid-term production growth.”
Like him, I think much of this will come from the firm’s big investments in lithium. The most notable of these was its $6.7bn purchase of Arcadium Lithium. Together with Rio Tinto’s previous lithium assets, these now represent the world’s largest lithium resource base.
Analysts forecast up to 12% annual growth in demand for the metal through to 2030. And projections are for battery-grade lithium carbonate to rise to around US$21,000 per metric ton by then from the current US$9,880 level.
Consequently, I am happy to retain this holding and think the shares worthy of consideration by other investors.
