beware of leverage

I think some people do not fully appreciate the effect of leverage on RIO's position. Simply put, leverage magnifies share price movements.

For example, a fall of 50% in share price from $40 to $20 seems pretty drastic, and would seem to mark a big drop in the value of the RIO business.

However in reality a 50% fall in share price from $40 to $20 is really a much smaller fall in what the market thinks is the value of RIO's business.

This is purely due to debt.

RIO had approx aud80b of debt at 30th June 2008 as per a report by S&P. I don't know how much cash they have currently, let's say it's 10b. RIO has 1.28b shares outstanding so its market cap at $40 a share is AUD$50b. This gives it a very rough enterprise value of $120b. This is the real valuation of RIO's business. If someone thought RIO's businesses were worth $120b, they would pay $50b for the company because they have to take on net debt of $70b as well.

therefore while the market values the company at 50% less if its share price falls from 40 to 20, the valuation of the business itself only falls from $120b to $95b, or a fall of 21%.

This has implications for people thinking that after such a big fall it has to bounce, and leverage up and take a position. In fact the fall in the valuation of RIO's business is much less than the dramatic fall the shares might suggest.

The extreme volatility of commodity prices and mining company profits over the cycles does not help the situation either.