Financial Analysis Of BHP And Rio Tinto Limited – Investment Recommendation

Description of operation and comparative advantages of the two chosen companies

The purpose of this report is to evaluate and compare two companies. The companies we have chosen in this report are in the mining and natural resources sector. They include Rio Tinto Limited (RIO) and BHP Billiton Limited (BHP). The report is divided nine sections as follows:

In section two, we discuss the operations and comparative advantages of the two companies.

In section three,we calculate the performance ratios of the two companies based on liquidity, profitability and capital structure.

In section four, we analyze the share price movement of the two companies within the last three years.

In section five, the factors that may have influenced the share price are identified.

In section six, the beta values and expected rates of return are determined using CAPM.

In section seven, the dividend policies under the two chosen companies are compared.

In section eight, a letter of recommendation is made to the investor, based on which company they should invest in.

About BHP Billiton Limited

BHP Billiton Limited (BHP) is a mining company. It produces iron ore and plays a large role in oil and gas. The company’s core areas include mineral exploration and production, exploration of petroleum, refining and production.. BHP’s, operations and interests are divided into Petroleum and Potash, Coal, Copper, Iron ore, and Nickel(BHP, 2018).

Comparative Advantages- BHP

BHP is currently the largest mining company in the world. Unlike its competitors, it is able to maintain profitability even at periods when the price of commodities falls making it very efficient.

Furthermore, BHP is well diversified across manycountries and resources, thus lowering its risk profile. However, the company’s profitability is volatile as it is subject to movements in commodity prices(The Australian, 2018).

About Rio Tinto

Rio Tinto Limited (RIO) is a company that is involved in metals and mineral exploration, production and processing. Rio Tinto’s portfolio of assets is made up of four major product groups: Aluminums, Iron Ore, Copper and Diamonds, Minerals and Energy(Rio Tinto, 2018).

Comparative Advantages- RIO

Rio Tinto is the second largest mining company in the world. It has operations in various regions including Australia. About 80% of the company’s revenue are through its iron ore operations. However, in addition to iron ore, Rio Tinto also produces coal, diamonds, bauxite, alumina, aluminum, uranium, salt copper and gold.

RIO is less diversified than BHP. Therefore, it is sensitive to currency movements and price changes in iron ore.  However, similar to BHP, RIO is an efficient producer of iron ore. Hence it is able to ‘withstand’ abrupt movements in iron ore prices. Furthermore, the company  is able to benefit when higher cost producers close production(The Australian, 2018).

Calculation and comparison of performance ratios of the two companies

Performance ratios can provide investors with information on the company’sliquidity, profitability and/or capital structure. Table 3-1 shows liquidity, profitability and/or capital structurefor BHP Billiton Limited over the past three years. Similarly, Table 3-2 shows the same ratios as above underRio Tinto Limited over the past three years.

Profitability Ratios
	2017	2016	2015
Return on Equity	21.03%	18.52%	27.63%
Return on Assets	9.61%	7.34%	8.37%
Return on Capital	16.39%	11.96%	12.08%
Leverage or Capital Structure
	2017	2016	2015
Debt to Equity Ratio	0.95	1.08	0.83
Liquidity
	2017	2016	2015
Current Ratio	1.85	1.44	1.27
Quick Ratio	1.53	1.16	0.94

Table 31: Financial Ratios- BHP Billiton Limited

Profitability Ratios
	2017	2016	2015
Return on Equity	22.02%	15.10%	15.87%
Return on Assets	10.53%	7.1%	7.14%
Return on Capital	19.12%	12.76%	10.44%
Leverage or Capital Structure
	2017	2016	2015
Debt to Equity Ratio	1.00	1.11	1.27
Liquidity
	2017	2016	2015
Current Ratio	1.69	1.60	1.53
Quick Ratio	1.38	1.29	1.22

Table 32: Financial Ratios- Rio Tinto Limited

Profitability ratios are used to assess a firm’s ability to use its assets or capital to generate profits. Examples of profitability ratio are return on assets (ROA),  return on equity (roe) and return on invested capital (ROIC).

ROA measures how efficiently the company’s assets have been used to generate profits.

ROA =

A large ratio suggests that the company has a good return on assets and hence is properly managed.

The ROA for BHP and Rio increased in 2017. However, Rio Tinto had a higher ROA in 2017 compared to BHP indicating that Rio Tinto was operating more efficiently.

Return on Equity- DuPont

The ROE ratio analyses the ability of a company to realize an adequate return on the capital invested by the owners or shareholder of the company. A large ratio shows efficiency.

However, it is important to note that the ROE alone does not say anything about the capital structure. As a result, analysts have split the ratio into three which is the basis of the DuPont Model(Ro, 2015)

Return on Equity

The ROE for BHP and Rio increased in 2017. However, Rio Tinto had a higher ROE in 2017 compared to BHP indicating that Rio Tinto is utilizing its capital successfully.

The ROIC analyses the return an investment releases to its contributors of capital. In other words, it indicates the efficiency of how a firm turns its contributor’s capital into profits (Investing Answers, 2017).

Return on Capital

The ROIC for both companies increased in 2017. However, Rio Tinto had a higher ROIC in 2017 compared to BHP indicating that the company is convertingits invested capital into profits.

Liquidity ratios assess the liquidity risk for the company i.e. the company’s ability or inability to pay its obligations in the short term. Examples of liquidity ratios are the quick (also known as the acid test ratio) and current ratio (Subramanya & Wild, 2009). A company that has a liquidity ratio above 1 suggests that there is a greater assurance that the company’s current short term obligations can be settled by their current assets. Hence, such a company company does not have a problem of liquidity.

Analysis of monthly share prices movements of the two companies within 3 years

Current ratio = Current assets/current liabilities

 Quick ratio = (cash and cash equivalents + marketable securities + accounts receivable) / current liabilities

In 2017, BHP and RIO showed a current ratio of 1.85 and 1.69 respectively. In the same year, they showed a quick ratio of 1.53 and 1.38 respectively. Both companies do not have a risk in liquidity.

These ratios analyse whether a company can meets their long term liabilities. An example of a ratio is the debt to equity ratio. In 2015-2017, the debt to equity ratio for both companies has been high (in some cases above 1). This suggests the companies have a lot of debt and hence presents a solvency risk.

The graph below shows the movements in the monthly share price over the last three years for Rio Tinto and BHP.

From the graph, we observe the following

• The share prices for BHP Billiton Limited and Rio Tinto Limitedare positively correlated with each other. Hence both share prices move in the same direction.
• Generally, movement of prices has been closely correlated.
• Returns have reached up to 23% in respect to BHP, and 21% in respect to Rio.

The graph below shows the two company’s share price movements, including movements inthe All Ordinaries Index.

From the graph, we observe the following:

• The share prices for BHP Billiton Limited and Rio Tinto Limitedare positively correlated with the All ordinary index. Hence both share prices move in the same direction as the All ordinary index.
• However, both company’s price movements are above that of the All ordinary index
• Hence their price movements are more volatile than the All ordinary index.

BHP Billiton Ltd

In 2016, BHP Billiton announced that its first-half results would include write-downs worth US$911m relating to closures and redundancies within the group, including the revaluation of its copper business and iron ore production. Following this announcement, share prices in BHP Billiton droppedby over 4% (Australian Associated Press, 2016).

In 2015, following a dam collapse in Brazil that resulted in the country’s worst environmental disaster, BHP’s share price fell across all markets, falling 22 per cent in Sydney and 23 per cent in both London and Johannesburg between 5 November 2015 and 30 November 2015. The falls wiped $25bn off the company’s value(Independent, 2018).

Rio Tinto Ltd

In 2017, Rio Tinto announced that it will buy back another $US 2.5 billion of shares. As a result, due to the announcement, share prices increased despite the drop in iron ore prices(Gray, 2017).

In 2014, Rio Tinto issued a statement that it had rejected to enter a takeover approach from Glencore Plc. This merger would have created a $160 billion mining giant. Following this announcement, Rio’s share price increased as much as 4.7 percent to a 9-day high. Glencore was down 2.1 percent (Reuters, 2014).

BHP Billiton Ltd

According to Reuters, BHP Billiton has a Beta of 1.26. This means that its share price is more volatile than the market index(Reuters, 2018).

Using the CAPM model, the required rate of return is determined as follows:

Identify any significant factors which may have influenced the share price of your chosen companies during the time frame.

Re = risk free rate + beta*(rm-rf)

Where rm-rf is the market premium.

In other words, return on equity is calculated using the risk free rate, market premium and a beta which shows correlation between the market returns and stock returns.

If the risk free rate is given as 5% and the market risk premium is given as 6%, then the required rate of return for BHP’s shares is calculated as 0.063%

Rio Tinto Ltd

According to Reuters, Rio Tinto has a Beta of 0.96. This means that its share price is less volatile than the market index(Reuters, 2018).

Using the CAPM model, the required rate of return is determined as follows:

Re = rf + beta*(rm-rf)

If the risk free rate of return was 5% and the market risk premium is 6%, then the required rate of return for the companies’ shares is calculated as 0.048%.

A dividend policy sets the guidelines for which a company uses to determine the proportion of profits it will pay out to shareholders as dividends (Investopedia, 2018).

BHP dividend’s policy states that it will provide a minimum 50% pay out of its earnings at all reporting periods. Furthermore, , in accordance with the company’s capital structure , the Board will assess the ability to pay an amount in addition to the minimum paymen (BHP, 2018).

Rio Tinto’s dividend policy will provided between 40% to 60% pay out of its earnings at all reporting periods. The board will take into account the results for the financial year, the outlook for its major commodities, the company’s the long-term growth prospects of the business and maintaining a strong balance sheetFurthermore, at the end of each financial period, the board will determine an appropriate total level of ordinary dividend per share,. The intention is that the balance between the interim and final dividend will be weighted towards the final dividend.

Rio is focused on generating cash and returning as much of it as possible to investors. Consequently, the company is committed to maximising shareholder value by maintaining a balance between cash returns to shareholders and investment into the business.

Taking into consideration the cyclical nature of the commodities industry, the board may include additional returns in periods of profitability and cash generation, (Rio Tinto, 2018).

Both companies have a constant pay out policy. This means dividends payment is a fixed proportion of the company’s earnings. Hence, the amount of dividend paid will move in direct proportion of the company’s earnings.

Calculation of Beta values and expected Rates of Return using the CAPM of the two chosen companies

This policy is preferred to many companies since it is related to a company’s ability to pay out as opposed to the progressive dividend policy where dividend amounts are maintained every year(Dhaval, 2018).

Company Letterhead

Address

Date

Dear Sir

Recommendation of Selected Company to include in Investment Portfolio

We have recently analyzed the performance of two firms, namely Rio Tinto Ltd and BHP Billiton Ltd in the same industry.

In this letter we explain which of the two selected companies should be included in your investment portfolio based on ratio analysis and other trends.

Results from our review

The table below summarizes the results from an analysis of the liquidity, profitability and capital structure ratio. The period under analysis was from 2014 to 2017.

Financial Ratios	2017	2016	2015
Return on Equity	21.03%	18.52%	27.63%
Return on Assets	9.61%	7.34%	8.37%
Return on Capital	16.39%	11.96%	12.08%
Debt to Equity Ratio	0.95	1.08	0.83
Current Ratio	1.85	1.44	1.27
Quick Ratio	1.53	1.16	0.94

Table 1: Financial Ratios- BHP Billiton Limited

Financial Ratios	2017	2016	2015
Return on Equity	22.02%	15.10%	15.87%
Return on Assets	10.53%	7.1%	7.14%
Return on Capital	19.12%	12.76%	10.44%
Debt to Equity Ratio	1.00	1.11	1.27
Current Ratio	1.69	1.60	1.53
Quick Ratio	1.38	1.29	1.22

Table 2: Financial Ratios- Rio Tinto Limited

Focus of review

The review sampled 2 mining firms .The key focus of the review was to assess suitability of the two shares for investment against the clients risk profile, which includes, but is not limited to, their knowledge and experience, investment objectives and financial situation.  

Results of Review

1. Profitability Analysis

The ROA, ROE and ROIC for Rio Tinto Ltd and BHP Billiton Ltd increased in 2017. However, Rio Tinto had a higher ROA in 2017 compared to BHP indicating that the company was operating more successfully.

1. Liquidity Analysis

In 2017, BHP and RIO showed a current ratio of 1.85 and 1.69 respectively. In the same year, they showed a quick ratio of 1.53 and 1.38 respectively. Both companies do not have a risk in liquidity. However, BHP appeared more liquid than RIO.

1. Capital Structure

In 2015-2017, the debt to equity ratio for both companies increased (in some cases above 1). This suggests the companies have a lot of debt and hence presents a solvency risk. The risk is higher with Rio Tinto than BHP.

While we believe both companies are good investments, our preference is in investment of BHP Billiton. This is because of their  diverse operations, its positive outlook for the commodities it produces has positioned it to outperform, and its undemanding valuation,  over the next years. Furthermore, the risk of solvency and liquidity appears to be lower than Rio. Therefore, we recommend that the client should invest in BHP Billiton Ltd

Please feel free to contact us should you want to discuss further.

Yours Faithfully,

John

Investment Analyst

References

Australian Associated Press. (2016, January 20). BHP Billiton shares fall to lowest point in decade after announcing write-downs. Retrieved from The Guardian: https://www.theguardian.com/business/2016/jan/20/bhp-billiton-shares-fall-to-lowest-point-in-decade-after-announcing-write-downs

BHP. (2018). About Us. Retrieved from BHP: https://www.bhp.com

BHP. (2018). Shareholder Information. Retrieved from BHP: https://www.bhp.com/investor-centre/shareholder-information/faqs

Dhaval, S. (2018). Meaning and Type of Dividend Policies. Retrieved from Financial Management: https://www.businessmanagementideas.com/financial-management/dividends/meaning-and-types-of-dividend-policy-financial-management/3968

Gray, D. (2017, September 22). Rio Tinto to buy back another $US2.5b of shares. Retrieved from The Sydney Morning Herald: https://www.smh.com.au/business/companies/rio-tinto-to-buy-back-another-us25b-of-shares-20170922-gymlxl.html

Independent. (2018, May 16). BHP Billiton to be sued by investors over dam collapse that caused Brazil’s worst ever environmental disaster. Retrieved from Independent: https://www.independent.co.uk/news/business/news/bhp-billiton-samarcoi-dam-collapse-legal-action-brazil-environmental-disaster-a8354126.html

Investing Answers. (2017). Return on Capital. Retrieved from Investing Answers: https://www.investinganswers.com/financial-dictionary/ratio-analysis/return-capital-3054

Investopedia. (2018). Dividends Policy. Retrieved from Investopedia: https://www.investopedia.com/walkthrough/corporate-finance/5/dividends/policy.aspx

Reuters. (2014, October 7). Bruised Rio Tinto rebuffs Glencore takeover approach. Retrieved from Reuters: https://uk.reuters.com/article/uk-rio-tinto-glencore-approach/bruised-rio-tinto-rebuffs-glencore-takeover-approach-idUKKCN0HV27020141007

Reuters. (2018). BHP Billiton Ltd (BHP.AX). Retrieved from Reuters: https://www.reuters.com/finance/stocks/overview/BHP.AX

Reuters. (2018). Rio Tinto Ltd (RIO.AX). Retrieved from Reuters: https://www.reuters.com/finance/stocks/overview/RIO.AX

Rio Tinto. (2018). About Us. Retrieved from Rio Tinto: https://www.riotinto.com

Rio Tinto. (2018). Dividends. Retrieved from Rio Tinto: https://www.riotinto.com/investors/dividends-7988.aspx

Ro, S. (2015, April 17). Goldman Sachs eplains the ‘return on equity’ formula that every CFA test taker must know. Retrieved from Business Insider: https://www.businessinsider.com/cfa-dupont-roe-model-2015-4?r=UK&IR=T

Subramanya, K., & Wild, J. (2009). Financial Statement Analysis. New York: McGraw-Hill Irwin.

The Australian. (2018). BHP BILLITON LIMITED. Retrieved from The Australian: https://markets.theaustralian.com.au/shares/BHP/bhp-billiton-limited

The Australian. (2018). Rio Tinto Limited. Retrieved from The Australian: https://markets.theaustralian.com.au/shares/RIO/rio-tinto-limited