Is BHP Billiton Limited grossly overvalued?

The world's largest diversified miner, BHP Billiton Limited (ASX: BHP), could survive a slowdown in commodity prices, but that doesn't make it a good investment. 

Ask one financial advisor and you'll probably get two different answers.

Is BHP Billiton Limited overvalued?

It's not an easy question to answer.

In addition to all the usual rigmarole of stock analysis, investors must come to grips with the fact that even if BHP Billiton is one of the world's lowest cost commodities producers, it still has no control over the price it receives for its products.

Ask ten first-year economics students however and they'll give you the same answer.

In a price-taking market, prices always return to the marginal cost of production.

In other words because BHP Billiton's iron ore is virtually the same as that from Rio Tinto Limited (ASX: RIO) and Brazil's VALE (NYSE: VALE), customers will take the lowest price possible regardless of the supplier.

One miner undercuts the other until prices slide towards the equilibrium – where the forces of supply and demand match and prices become stable.

It's anyone's guess as to the where the forces of supply and demand will take the equilibrium.

However, the individual retail investor can glean valuable insights into a commodity's cycle by observing historical prices over a long period.

Figure 01. Major commodity prices have plunged in recent times

Source: Indexmundi.com

As the above graph shows clearly, something caused prices of BHP Billiton's most valuable commodities to rally from the early 2000's until 2010-2011.

Many analysts and economists attribute rapid demand growth (and rallying spot prices) to China's unprecedented hunger for raw materials, as it sought to industrialise its entire country by driving its infrastructure spend.

Figure 02. BHP Billiton's top four sales destinations

Source: BHP Annual Reports

To put its growth into perspective, according to Bill Gates' blog, China used 6.6 gigatonnes of cement in the three years between 2011 and 2013 – that's more than the United States did throughout all of the 20th century.

As a result of its almost incomprehensible increase in demand for all raw materials (not just cement), producers right around the world ramped up production by buying new mines and tenements and undertaking years of construction.

Investing huge amounts of money to meet demand is all well and good – until it isn't. 

Indeed, China is now transitioning its economy from infrastructure-led to consumption-based.

We've all heard the stories. But more than 20% of all homes (including units and apartments) are currently empty in China. Analysts estimate that even if the construction stopped dead, the surplus would take years of current urbanisation rates to fill.

Perhaps unsurprisingly China is expected to produce excess amounts of steel in coming years. Meanwhile, copper and coal markets are in surplus, evident from the fall in spot prices. Both markets are expected to remain depressed for some time.

Closer to home, we saw BHP Billiton's revenue peak at over $US70 billion in 2012 then drop to $US67 billion in 2014. EBITDA (earnings before interest, tax, depreciation and amortisation) fell 14% in that time.

In just a couple of months, BHP Billiton will report its full year results. Current analyst forecasts are pointing to a 25% drop in profits per share.

Valuation

Even if we expected BHP Billiton's profits to fall by 25% in 2015 – remember in the first half of its 2015 financial year it reported a 47% fall in profits – it shares still aren't cheap by historical standards.

Figure 03. BHP Billiton's valuation versus its return on invested capital

Source: BHP Annual Reports, and forecasts.

So with the possibility of further falls in commodities, coupled with a fair or overvalued market price, it's probably a good idea to avoid buying shares in BHP Billiton, at least for the foreseeable future.