Unfortunately, these declines could be just the beginning as, using historic figures, BHP still looks expensive.
Over the past 10years, BHP has traded at an average forward P/E ratio of around 10. However, at present levels the company is currently trading at a forward P/E ratio of 11.9, implying that the firm is overvalued by around 20%.
With this being the case, BHPs share price would have to drop to 1,371p, a full 14.6% below current levels, before the companys valuation reverted to its historic average. Whats more, things could get worse for BHP if the price of iron ore starts to fall once again.City analysts have estimated that a $1 drop in the average iron ore price, wipes out $135m of annual net profit after tax at BHP.
So, as the price of iron ore has fallen around $40 per tonne since this time last year, its reasonable to assume thatBHP is likely to have seen $5.4bn of potential profit wiped out. As a result, analysts keep downgrading the companys earnings forecasts.
Still, BHP operates around a four pillars strategy. In essence this means that the companys production is focused on four main commodities, oil, iron ore, coal and copper.
This diversification means that while the companys margins from iron ore production fall, other divisions will continue to churn out the cash.
For example, BHP is currently drilling somewhere in the region of 400 oil wells per year across North America. The drilling programme is costing the company around $4bn per annum but in the end it should be worth it. These operations are expected to be free cash flow positive by 2016 and the company is currently producing 670,000 barrels of oil per day.
For Foolish long-term holders, this is great news. BHPs diversification means that the company can easily weather commodity market weaknesses, preparing itself for growth when prices rebound. Indeed, BHPs management is already trying to unlock value for investors by spinning off non-core operations, and theres been talk of a stock buyback.
Paid to wait
Further, at present levels BHP supports a dividend yield of 4.6%. The payout is covered twice by earnings. The companys earnings can fall by as much as 50% before the payout comes under pressure. Current City estimates are calling for BHPs earnings to fall by 12% this year to 137p per share, easily covering the projected dividend payout of 77.3p, with room to spare.
With this being the case, investors will be paid handsomely to hold BHPs shares while they wait for the companys earnings to start growing again.
The bottom line
All in all, BHPs shares could fall further if the companys valuation declines to its 10-year average. However, the company continues to attract investors for growth and, over the long term, I believe shareholders are set to profit.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.