Most analysts love Rio Tinto Plc, which has an average rating of buy. But there's reason to believe the stock may be overvalued at today's price of $60.5 per share. Let's look at the fundamentals ourselves and see if we reach a different conclusion than the analyst community.
The first step in determining whether a stock is overvalued is to check its price to book (P/B) ratio. This is perhaps the most basic measure of a company's valuation, which is its market value divided by its book value. Book value refers to the sum of all of the company's assets minus its liabilities -- you can also think of it as the company's equity value.
Traditionally, value investors would look for companies with a ratio of less than 1 (meaning that the market value was smaller than the company's book value), but such opportunities are very rare these days. So we tend to look for company's whose valuations are less than their sector and market average. The P/B ratio for Rio Tinto Plc is 1.9, compared to its sector average of 2.08 and the S&P 500's average P/B of 2.95.
Modernly, the most common metric for valuing a company is its Price to Earnings (P/E) ratio. It's simply today's stock price of 60.5 divided by either its trailing or forward earnings, which for Rio Tinto Plc are $5.27 and $4.21 respectively. Based on these values, the company's trailing P/E ratio is 11.5 and its forward P/E ratio is 14.4. By way of comparison, the average P/E ratio of the Basic Materials sector is 10.03 and the average P/E ratio of the S&P 500 is 15.97.
If a company is overvalued in terms of its earnings, we also need to check if it has the ability to meet its financial obligations. One way to check this is via the so called Quick Ratio or Acid Test, which is the sum of its current assets, inventory, and prepaid expenses divided by its current liabilities. Rio Tinto Plc's Quick ratio is 1.374, which indicates that that its total liquid assets are sufficient to meets its current liabilities.
One last metric to check out is Rio Tinto Plc's free cash flow of $27.97 Billion. This represents the total sum of all the company's inflows and outflows of capital, including the costs of servicing its debt. It's the final bottom line of the company, which it can use to re-invest or to pay its investors a dividend. With such healthy cash flows, investors can expect Rio Tinto Plc to keep paying its 6.5% dividend.
Shares of Rio Tinto Plc appear to be overvalued at today's prices — despite the positive outlook from analysts. But sometimes stocks with inflated valuations turn out to be strong performances for years, and even decades, such as Amazon. So be sure to do your own due diligence if you are interested in taking a long position in RIO.
