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Why these big miners are still too cheap for me to sell

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Mega miners BHP Billiton (LSE: BLT) and Anglo American (LSE: AAL) are up by 70% and 280% respectively this year. If you bought shares earlier in the year, when prices were much lower, the temptation to take some profits is probably strong.

But wait. If you’re a longer-term investor and have owned these shares for several years, your holding will probably still be in the red. From your perspective, things aren’t so rosy.

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Situations like this are common with cyclical stocks. The good news is that there’s a simple way to decide what you should do. Let me explain.

Forget the price

Billionaire investor Warren Buffett once said that “price is what you pay, value is what you get”. What this means is that the price of a stock isn’t a reliable indicator of how much it’s really worth. Over the years, the price of a stock tends to cycle above and below its fair value.

The secret to making money from stocks is buying them when they’re trading below their fair value. History suggests that earnings and valuations tend to move from extreme levels back to long-term average levels over time.

One tried-and-tested method that I find useful when valuing a stock is the PE10. This is simply the current share price divided by a company’s 10-year average earnings per share.

A low PE10 indicates that the stock is cheap, relative to its historic earning power. A high PE10 suggests that the stock looks overvalued, relative to its past performance.

Anglo could be mega cheap

The easiest way to find 10 years of earnings per share data is to download some annual reports. Most companies include a five-year snapshot in each annual report, so you only need two annual reports to get 10 years of earnings data.

I’ve crunched the numbers, and can tell you that Anglo American currently trades on a PE10 of just 7.6. That’s pretty low. But the firm’s cash flow and profits have risen more quickly than expected this year, thanks mainly to a strong rebound in coal and iron prices.

Earnings forecasts for 2016 have risen from $0.68 per share one year ago to $1.13 per share today. Analysts now believe that there’s now a good chance Anglo American will restart dividend payments in 2017, albeit at a pretty low level.

We’ll know more when Anglo publishes its full-year results in February. But in the meantime I’m quite comfortable holding onto my shares in the firm.

BHP is different

Anglo-Australian miner BHP Billiton is a slightly different business. Its finances were stronger than those of Anglo when heading into the mining downturn. BHP’s commodity exposure is also different. Around a quarter of profits come from oil and gas, for example.

BHP’s strength meant that its shares weren’t sold off as brutally as those of Anglo. Valued on a PE10 basis, my calculations suggest BHP Billiton has a PE10 of 8.4 at the moment.

Although the shares trade on a forecast P/E of about 20, it’s worth remembering that analysts’ forecasts tend to lag behind events. Forecasts for BHP are still lower than they were one year ago, even though the market is now recovering. I expect further upgrades as we head into 2017.

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Roland Head owns shares of BHP Billiton and Anglo American. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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