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Fortescue Metals Group Limited: Is this the best value stock in the ASX200?

Credit: Chatham House

In his book entitled `The Most Important Thing’, legendary value investor Howard Marks articulates two simple rules for investors:

“Rule number one: most things will prove to be cyclical.”

“Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”

Marks goes on to state that: “Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.”

Fortescue Metals Group Limited (ASX: FMG) has certainly looked a little troubled of late. Volatile iron ore prices and decreasing demand for its lower quality iron ore have dented Fortescue’s profits and restricted its share price over the last few years.

However, extrapolating such factors into the future may have led investors to severely undervalue the company.

Fortescue is currently trading at a P/E ratio of 5.6, and an enterprise multiple of 2.9 based on the trailing 12 months (an enterprise multiple is the enterprise value of a company divided by its EBITDA).

In fact, you’re unlikely to find a cheaper company based on enterprise multiples on the ASX. Similarly, Fortescue has the lowest Sonkin ratio of any company in the ASX200.

The Sonkin ratio is a tax-adjusted enterprise multiple and helps you to understand how much you’re paying for a company’s after-tax earnings. Fortescue currently trades at a Sonkin ration of around 6.7, meaning that at the current market price, investors are paying $6.70 for every dollar of after-tax earnings.

For comparison, BHP Billiton Limited (ASX: BHP) trades at a Sonkin ratio of over 20, Rio Tinto Limited (ASX: RIO) over 15, and Newcrest Mining Limited (ASX: NCM) at over 28. Three of the four big banks are over 20. REA Group Limited (ASX: REA) is over 45.

On top of this, the current dividend is over 10%. With a 30% increase in the spot iron price over the last few months, the bottom of the cycle may be near for Fortescue.

Regardless, as Howard Marks says, some of the greatest opportunities for loss and gain come when people forget that cycles will prevail. And fewer industries have proved to be more cyclical than the basic materials industry.

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Motley Fool contributor Stewart Vella owns shares of Fortescue Metals Group Limited. 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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