Rio Tinto (LSE: RIO) (NYSE: RIO.US) had a rather unusual year last year.
Indeed, the mining behemoth spent more cash on the purchase of property, plant and equipment than it generated through operating activities. In other words, its free cash flow was negative.
This was unusual because in each of the previous four years, the business had generated high levels of free cash flow, with net operating cash flows being significantly higher than capital expenditures in all four years.
Of course, capital expenditure is notoriously ‘lumpy’, with it lacking consistency from year to year. However, despite Rio Tinto having a negative free cash flow yield based on last year’s figures, I believe that if we were to take an average of the last five year’s free cash flow then it would provide a more accurate picture of the company’s free cash flow yield and, subsequently an indication as to whether it is worth buying at current levels.
Since free cash flow averages £3.1 billion per annum over the last five years, this equates to a free cash flow yield of 6.7% at current market prices. This is very impressive and shows that Rio Tinto offers good value for money at current price levels.
Indeed, even a free cash flow yield of 5.5% would be better than many of Rio Tinto’s peers and could still offer relatively good value for money. Were shares to trade on such a yield, it would mean they would move up by around 22% from their current price of 3,264p, with such a move being possible over the medium to long term.
Of course, the last five years are not going to be perfectly mirrored in the next five. Moreover, net operating cash flow could be lower in future years as demand for metals such as iron ore remains subdued. However, it does seem as though capital expenditure could be lower too, as Rio Tinto invests a smaller amount in the business due to the possibility of weaker demand.
The net effect of this could still be strong free cash flow, as has been delivered (on average) over the last five years. This, coupled with the potential for a pickup in emerging market growth prospects and the low cost curve that Rio Tinto enjoys due to its sheer scale, means that upside of 22% could be on the cards.
> Peter owns shares in Rio Tinto.