Is Rio Tinto a screaming buy?

The company is now generating a lot of cash and has attractive dividend paying prospects. Given that and the fact that the share price is fifth lower than the 3,503p of last August, I rate the shares as highly attractive at this level.

It is my opinion that Rio Tinto (RIO) shares at 2,769p (last seen) are worth buying. They have not been on my notional selling list because the company has transformed itself over the last year or so. Most importantly, it has is much improved as a generator of cash, which benefits dividends.

The improvement in its operations are reflected in the fact that the shares have handsomely outperformed the likes of Anglo American and BHP Billiton by some  distance over the past year, and done a bit better than the Glencore, the company that mounted that cheeky bid attempt on Rio a little time ago. Thank the Lord that the shareholders saw it off and retained the benefit of Rio’s investment and cash flow, despite investment then being the source of fashionable investment bank analyst criticism. This modern form of so called market economics, the one that does not do investment, is a problem.

Rio is a picture of great change in the last three years. Capital spending peaked in 2012 at $17.6 billion. Last year it was only $8.2 billion. Operating cash flow was much higher last year at $14.3 billion in contrast to $9.4 billion in 2012, putting the shares on an estimated price to operational cash flow ratio of  only 5.5 times. That operating cash flow is equivalent to an estimated 497p a share. In last year’s year end balance sheet cash and near cash holdings were reported as $12.4 billion – 21% up on the year end cash figure in 2013 and nearly 70% higher than the year end cash figure of $7.3 billion two years earlier in 2012.

So although we have had a collapse in ore prices (and earnings per share for Rio in consequence) we have also had a rise in cash flow. According to the market consensus figures I use, earnings per share on like for like basis fell 9% last year and are estimated to fall about 47% this year to 169.4p, putting the shares on 15.7 times earnings. I add that the consensus also has the estimated dividend yield for this year at 5.4%. Is that a safe looking dividend? The market consensus thinks so because it has the dividend yield at 5.6% for next year; pretty handsome given that the current ‘bird in the hand’ average dividend yield for the FTSE 100 Index company is 3.5%.

Moreover, the cash flow figures for last year support that consensus optimism about dividend progress at Rio. After capital spending and the cost of the dividend that year, the company still had $2.4 billion of the operating cash flow left – almost the amount by which balance sheet year end cash rose. I also point out that last year’s operating cash covered the amount paid out as dividend by more than 3.8 times. Put another way, operating cash as a margin of group sales last year, was a flicker under 30%, according to my calculations. Moreover, the quality of Rio earnings was remarkably high given the cash element in them. Another indicator of value was the attributable net asset backing, which I estimate to have been in the region of 390p last year or around 14% of the share price.

After two years of earnings decline, the market consensus is estimating a 20% increase in earnings per share next year to around 203p, putting the shares on a prospective, estimated price to earnings ratio of 13.6 times (or 11.7 times those earnings alone if you knock of an estimated 390p of attributable assets). That is accompanied by the aforementioned, attractive, estimated forward dividend yield of 5.6%.