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Fortescue Metals Group Limited: Are the shares a bargain?

Fortescue Metals Group Limited (ASX: FMG) is an Australian iron-ore company that owns and operates integrated operations spanning three mine sites in the Pilbara, the five berth Herb Elliott Port in Port Hedland and a heavy haul railway.

Shares of Fortescue currently trade at $4.30 – a decrease of one third over the previous twelve months. The 52 week high is $6.42, and the 52 week low is $4.24. With earnings per share of $0.871 in 2017, shares are currently trading at a price to earnings ratio of just under 5 based on 2017 earnings. Analysts have forecast earnings of $0.57 per share in 2018, a decrease of 34% on the previous 12 months. This puts the current share price at a price to earnings ratio of 7.6 based on forecasted 2018 earnings.

In the last 10 years, Fortescue has grown its book value at an annualised rate of 27.6%. The current price to book ratio is 1.05. Over the same period, Fortescue has grown earnings at an annualised rate of 10.9%, and its cash flow at 14.3%.

Over its last 5 financial reports Fortescue’s return on invested capital has ranged from 5% to 22%, and has averaged 14%. This represents an average return over that period.

In 2017, Fortescue paid a fully franked dividend of $0.45.

So what are the shares worth?

According to its 2017 financial report, Fortescue held $5.65 billion in interest bearing debt, and $2.39 billion in cash and equivalents. At a current market cap of $13.26 billion, Fortescue’s enterprise value is around $16.53 billion. With earnings before interest, tax, depreciation and amortisation (EBITDA) of 6.1 billion, the company’s enterprise multiple is around 2.7. This tells me that the shares are extremely cheap at the current price.

A discounted cash flow model using only half the historical growth rate in book value as the growth rate for the next 10 years and then a 2% growth rate thereafter, capital expenditures equal to those in 2017, and a required return of 10% per year places the intrinsic value of the shares around $18.63 – far in excess of the current share price.  This is, of course, heavily dependent upon the growth rate and your required return, although I doubt that tinkering with any of the inputs would result in a price close to the current market price.

FOOLISH TAKEAWAY.

Based on the above, shares are probably worth a lot more than they currently are. Undoubtedly, Fortescue has some headwinds that it will need to push through – companies are rarely this cheap without some sort of obvious obstacle. However, in this case, the price is low enough for me and I’d be a buyer at the current price.

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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 Scott Phillips.

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