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Why Rio Tinto plc could hit 4,000p in 2017

Shares of mining giant Rio Tinto (LSE: RIO) rose on Wednesday after the group reported 2016 profits ahead of expectations. Shareholders will be treated to a bigger-than-expected dividend and a $500m share buyback.

These results make it clear that Rio’s income credentials are attractive. But the group’s earnings per share are expected to rise by a further 40% in 2017. Will Rio shares hit 4,000p as the recovery continues?

Mining cash for shareholders

Rio spent several years cutting costs. That hard work paid off last year as the prices of coal, iron ore and copper all rebounded strongly. The group’s underlying earnings rose by 13% to $5.1bn, beating City forecasts of $4.9bn.

Importantly for shareholders, Rio’s rising profits also translated into free cash flow. Rio generated free cash flow of $5.8bn in 2016. That gives the stock a price/free cash flow ratio of about 14, which seems fairly affordable to me.

Strong cash generation helped Rio to reduce net debt by 30% to $9.6bn, making Rio one of the least-geared big miners. Shareholders will receive a total dividend of 170 cents per share for 2016, giving a yield of 3.9%. Forward earnings will be lifted by a $500m share buyback.

Can Rio climb higher?

The latest consensus forecasts give Rio a 2017 forecast P/E of 11.7, with a prospective yield of 4.6%.

A share price of 4,000p would imply a P/E of about 13, or less if consensus forecasts continue to rise. That seems plausible to me, although investors need to remember that a stronger pound would reduce the value of Rio’s rising earnings.

On balance, I’d be cautious about targeting 4,000p. At current levels, this could be one to buy on the dips.

An unmissable bargain?

Bus and train operator Go-Ahead Group (LSE: GOG) appears to be making a stealth recovery from last year’s sell-off. The firm’s stock has now risen by 28% from its July lows of 1,800p. Despite this, the shares still look very affordable, with a forecast P/E of 10 and a prospective yield of 4.5%.

Go-Ahead is attractive to many value and quality investors because it generates a lot of cash, and has a high return on capital employed (ROCE). Last year’s free cash flow of £68m comfortably covered the group’s £41.2m dividend payout. The group’s ROCE of 18% suggests it’s able to generate returns significantly above its funding costs when investing in new opportunities.

Of course, there are some good reasons why this stock trades on such an undemanding valuation. The outlook for growth appears uncertain. Adjusted earnings are expected to be broadly flat in 2016/17, and are only expected to rise by 2.5% in 2017/18.

As the operator of the Southern rail franchise, Go-Ahead says rail costs will be higher than expected this year due to disruption from strike action. However, the latest news suggests that the worst of the strike action is over.

Meanwhile, the group’s bus division is trading in line with expectations. Go-Ahead also has a pipeline of new opportunities in overseas rail markets.

In my view the potential upside is attractive here. Patient investors should receive an attractive income while they wait for Go-Ahead to identify new growth opportunities.

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Roland Head owns shares of Rio Tinto. The Motley Fool UK has recommended Rio Tinto. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.