Shares in Rio Tinto (LSE: RIO) and BHP Billiton (LSE: BLT) have crashed by 23% and 26% respectively this year, drastically underperforming the FTSE 100.These declines have made the companies look extremely attractive to value hunters like myself, but for the time being, Im staying away.
The trouble is, highly cyclical mining companies like BHP and Rio dont deserve to trade at high valuations. Whats more, as a value investor Im unwillingthe buy either of these two companies unless theyre trading at a deep discount to intrinsic value.
Simply put, intrinsic value is the actual value of a business or an assetbased on an underlying perception of its true value including all aspects of the business, both tangible and intangible.However, its almost impossible to calculate an intrinsic value for these two miners with so much turmoil in emerging markets.
Impossible to value
There are few analysts that know more about company valuation techniques thanAswath Damodaran, Professor of Finance at the Stern School of Business at NYU, but even he is having trouble placing a value the shares of miners such as BHP and Rio.
This time last year, Professor Damodaran tried to evaluateVale, the worlds third-largest iron ore producer after BHP and Rio. A detailed analysisconducted in November 2014 led the professor to conclude that the companys shares were worth $13.60, which was 60% above what were they were trading at the time.
Six months later, Professor Damodaran revisited hiscalculationsand found that Vales intrinsic value had dropped to $10.71. And then, back in September the professor revisited Vale for a third time. Plugging the most recent set of figures into his calculation led to the conclusion that Vales intrinsic value had dropped further to $4.29. (Vale is currently trading at $4.36.)
Its reasonable to assume that both BHP and Rios intrinsic values have fallen in line with Vales over the same period.
Even the Citys top mining analysts, who know the sector inside out, are struggling to predict accurately what the future holds for BHP and Rio Tinto.
This timelast year analysts were expecting BHP to report earnings per share of $2.56 for 2016, but now analysts only expect the company to reportearnings per share of $0.72 for full-year 2016. Similarly, City estimates for Rios earnings per share have fallen from $5.10 to $2.40.
The point here is that the future is extremely uncertain for miners. As a result, it is almost impossible to produce an accurate valuation for the companies.
Indeed, if youd purchased BHP shares this time last year,at 1,000p, based on the prevalent City forecasts at the time, BHP would have been trading at a forward P/E of around 6. 12 months on and at 1,000p BHPs valuation has surged to 27.4 times forward earnings.Rio is currently trading at 13.7 times forward earnings.
That said, BHP and Rio might make good income investments. Rio currently offers a dividend yield of 6.3% and BHP supports a yield of 7.8%. However, without any pricing power its difficult to sayhow much longer dividend payouts will be maintained at present levels.
Watch from the sidelines
Until the mining sector’s outlook improves, it might be wise for investors to watch from the sidelines.
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