Is the 18.5% fall in South32 Ltd shares a buying opportunity?

It could be time value investors sharpen their pencils on South32 Ltd(ASX:S32).

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While there are arguably very few "sure things" when it comes to investing in the stock market, it would seem safe to assume that many value investors understand the forces at work during a demerger or spin-off situation.

Since listing in July this year, the share price of BHP Billiton Limited (ASX: BHP) spin-off South32 Ltd (ASX: S32) has slumped 18.5%. In comparison, BHP's shares are down 21%, while the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) has given up just under 10%.

It's certainly not what original South32 shareholders would have hoped for but in many ways it isn't surprising. Here's why:

Firstly, had the spin-off never occurred, original BHP shareholders would most likely be in roughly the same financial position as they are now particularly considering the downtrend in resource and energy markets.

Secondly, often spin-offs do underperform in the first few months post demerger as some shareholders are either forced to or choose to dispose of their shares. This selling pressure pushes the price down in the short term.

The stage could now be set for South32.

While there are initial forces which can cause underperformance, in the longer-term, a spun-off company which is free of the parent company and able to focus more intently of its own business model can excel.

The pro forma full year results and strategic initiatives being undertaken certainly suggest earnings could improve from here:

Operating revenue fell 7% to US$7.7 billion

Earnings before interest and tax jumped 52% to US$1 billion

Profit after tax slumped 56% to US$28 million

Net debt of US$402 million

Value?

With a market capitalisation of just under $8.9 billion, the enterprise value (EV) of South32 is approximately $9.3 billion. With EBIT of $1 billion, the stock is trading on an EV/EBIT ratio of 9.3x. That might not be a bad entry point for long-term value investors given where we are at in the commodity cycle and also considering the cost-out program currently underway in the streamlined South32.

Motley Fool contributor Tim McArthur has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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