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Here’s why National Australia Bank and Rio Tinto Limited look risky

In the share market, prices are relative. That is, relative to the cost of placing your money in a bank account, buying a bond or to a company’s peers. Before you decide to invest in any company, you should first compare it against its peers.

Just like National Australia Bank Ltd (ASX: NAB) is the ugly duckling when it’s compared to its big bank rivals, so too is Rio Tinto Limited (ASX: RIO) compared to BHP Billiton Limited (ASX: BHP). However, as the market’s proven on a number of occasions, focusing our attention on the stocks currently out of favour can make for a great investment strategy.

Let’s take a closer look at these two stocks.

NameNational Australia Bank Limited Rio Tinto Limited
Stock tickerASX:NABASX:RIO
Recent share price$33.46$62.16
Market Cap$79 billion$27.4 billion
Price-Earnings Ratio | 10-year Average13.5 | 12.58.8 | 11.6
Trailing Dividend Yield5.6%3.4%
Price to Book ratio1.832.26

Data sourced from Morningstar

Although NAB may appear to be slightly pricey  based on historical price-to-earnings ratios (P/E), in the current low interest rate environment high yielding dividend stocks (such as NAB) will be in demand as term deposits are dumped in search of greater returns. However, when compared to the valuations of its peers, such as Commonwealth Bank of Australia (ASX: CBA), it could almost be excusable to think NAB is undervalued (although I’m not going to call it that!). However, we need more than a simple price-earnings ratio to understand a stock’s true valuation.

As noted earlier, NAB had a troubled past and its UK operations continue to be a burden on management. In its most recent half year, NAB produced a net interest margin (which is essentially the profit margin of bank earnings) of only 1.96! Significantly lower than both Westpac Banking Corp (ASX: WBC) and Australia and New Zealand Banking Group (ASX: ANZ).

So there’s two things to take away from this: First, its stock isn’t cheap and second, it’s not exactly a healthy bank either! As such, it’s not a buy in my book.

Looking at the table above you’d easily be mistaken for thinking Rio is undervalued relative to its 10-year average annual P/E. As seasoned investors know a low P/E can be a sign of a troubled business or outlook. In Rio’s case that assumption would be correct.

With iron ore prices tipped to fall further than they already have, all iron ore miners are trading cheap. And for good reason. Simply put, lower iron ore prices means less revenue, less profit and lower share prices. It should be noted iron ore accounts for over 90% of Rio’s underlying earnings!

Here’s how you can still profit!

Even though neither of these two companies are a standout buy, we’ve got one dividend idea you shouldn’t ignore! Simply click here for your FREE copy of "The Motley Fool's Top Dividend Stock for 2014." -- its FREE!

Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies. 

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