Value investing is all about finding stocks that are trading below their intrinsic value.

Legendary value investor Warren Buffett popularized the term “intrinsic value” to describe the true worth of a company, which may or may not be aligned with the current share price of a stock.

Investors who buy value stocks typically look for low valuation multiples, usually measured by the price-to-earnings ratio. But investors also need to be sure to avoid value traps—these are stocks that look cheap on the surface, but have significant underlying problems.

Cleveland Cliffs (CLF) is a value stock with a very low valuation and a high dividend yield above 4%. It could generate very high future returns if the company executes on its turnaround, but only investors with a high tolerance for risk should consider buying the stock.

Business Overview and Recent Events

Cleveland Cliffs Inc. is the largest and oldest iron ore mining company in the United States. It supplies iron ore pellets to the North American steel industry, from its mines and pellet plants in Michigan and Minnesota. The company is struggling right now, due to weak demand. Revenue declined 23% in the 2019 fourth quarter, and 13% for the full year, mostly due to lower sales volumes.

Cleveland Cliffs could see better days ahead, as the company is investing heavily in growth. For example, in December 2019 the company announced it will acquire AK Steel in a $3 billion all-stock transaction. The combination will create a company with total revenue above $8 billion.

The acquisition further integrates Cleveland Cliffs’ business model while expanding its steel exposure. The company also expects significant cost savings, with annual cost synergies of approximately $120 million. The acquisition is expected to be accretive to earnings-per-share in 2020.

Valuation Analysis

Cleveland Cliffs stock has a forward price-to-earnings ratio just above 5, which is a fairly low valuation level. On the surface, it seems the stock is significantly undervalued, particularly given its potential growth catalyst in the form of the AK Steel acquisition. However, commodity businesses typically trade at discounted valuation multiples to account for their volatile financial performance.

That said, Cleveland Cliffs has an attractive 4.4% dividend yield. The combination of future earnings-per-share growth, expansion of the P/E multiple, and dividends could create total annual shareholder returns in the mid-teens over the next several years.

When it comes to commodity businesses, investors should always keep an eye on debt levels. Overly-indebted commodity producers can experience significant trouble if commodity prices decline or demand slows down. Indeed, the AK Steel acquisition will result in a pro-forma debt to adjusted EBITDA ratio of 3.5x.

Overall, we view Cleveland Cliffs as a value stock with the potential for high shareholder returns, with the major caveat that investors need to have a high tolerance for risk. Commodities are a boom-and-bust industry, meaning investors will need to accept high volatility in exchange for high potential returns.

Final Thoughts

The appeal of value investing is to buy shares of companies that are temporarily trading at a discount. Value stocks typically also pay dividends, meaning investors have the potential to earn outsized future returns through a rising share price as well as dividends.

The potential danger of buying stocks with extremely low valuations is that they could be value traps. Value stocks are appealing at first glance, but can deliver poor returns if their fundamental deterioration continues.

Ben Reynolds is CEO of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth stock portfolios for the long run.