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Is Rio Tinto Limited a buy at this share price?

Credit: iStock

The Rio Tinto Limited (ASX: RIO) share price is currently around the $46.22 mark, having recovered somewhat after hitting a five-year low of $36.53 in early February 2016.

But it’s a long way from its 10-year high of $124.19 set in May 2008, and its five-year high of $84.53, the share price reached in July 2011.

Interestingly, the iron ore price had only just begun its rise in Mya 2008, and average US$60 a tonne during that month. in July 2011, iron ore was at US$173 a tonne, slightly off the highs of over US$187 a tonne reached in February 2011.

As the world’s lowest cost producer, Rio Tinto can virtually survive with the iron ore price anywhere above US$30 a tonne. UBS estimates Rio and BHP Billiton Limited (ASX: BHP) can breakeven at a benchmark price of US$29 a tonne, while Fortescue Metals Group Limited (ASX: FMG) and Gina Rinehart’s Roy Hill are not far behind.

And while many investors might view Rio Tinto as a diversified miner, in the 2015 financial year, 87% of total group underlying earnings came from iron ore. The company’s coal and diamond & minerals businesses have ultra-thin margins, generating just 5% of earnings – the same as copper, while aluminium is still a major earner for the group.

Despite what might happen to other commodities prices, where the iron ore price goes, so too will Rio’s earnings.

Currently, iron ore is priced around US$55.57 a tonne, already down 20% from its peak of over US$70 a tonne set on April 21, and further falls are expected, as rational behaviour filters into the Chinese futures markets.

The iron ore market is still in oversupply, and more is coming on stream over the next couple of years too. That could replace higher cost, low-quality iron ore over time, but could still force the iron ore price lower in the short to medium-term.

Adding to the oversupply, Rio shipped 270 million tonnes of iron ore in 2015 and expects to produce between 330 and 340 million tonnes in 2016 – although delays in its automated driverless train program have cut an estimated 20 million tonnes off total production.

Foolish takeaway

Analysts are forecasting earnings per share for 2016 to drop by around 50% compared to 2015 to around US$1.48 in 2016 and US$1.60 in 2017. At current exchange rates, that suggest Rio is trading on a forward P/E ratio of over 20x (23x for FY16 and 21.3x for FY17).

Even if you ignored the fact that resources companies have destroyed so much shareholder capital in the past 10-20 years (or longer), Rio’s share price looks highly expensive, particularly when you consider the company’s long-term average is between 9-11x – and iron ore prices are expected to fall much further.

Look out below.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

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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