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While browsing the various fundamental evaluations of mining companies
made by investors on internet message boards, I have consistently seen two
valuation methodologies - the in
situ method and the cash flow method - used frequently, while the
traditional net asset value (NAV) method used by professionals is neglected
or not used at all. The NAV method, I believe, is superior to the other two,
and the following is a defense of this valuation
technique.
The in situ valuation is the
easiest valuation methodology to use for a mining company. It consists of
merely adding up a company's resources and dividing this into the market cap
of the company. If this quantity is less than the industry average, the
company is said to be "undervalued." This method is easy, and it
allows quick comparisons of dozens of mining companies. Unfortunately,
however, it has a vast multitude of weaknesses:
1.
It does not take into account a company's other assets and liabilities, such
as cash on hand or long term debt.
2.
It does not take into account the capital cost (either initial or sustaining
capital) necessary to extract the ounces from the ground.
3.
It does not take into account the operational cost necessary to extract the
ounces from the ground.
4.
It does not take into account future rises or falls in the commodity price.
5.
It does not take into account the mineability (or
lack thereof) of the resource. A proven/probable ounce is valued no higher
than an inferred ounce (unless, of course, one uses different $/oz figures
for the different resource classifications.)
6.
It does not take into account the time necessary to extract the resource, or
the time value of money.
7.
It does not take into account the capital structure of a company.
8.
It does not take into account the recovery rate of the resource, which can
vary widely.
9.
It is a relative valuation; it relies on the whole sector being valued
accurately.
10.
Using "equivalent" in
situ resources does not take into account differences in the
underlying resource fundamentals. The silver in a silver-lead polymetallic deposit, for example, may be in contango,
but the lead may be in backwardation.
11.
It does not take risk into account.
12.
Industry "average" $/oz figures are statistically suspect; the
deviation from the average is very large for many companies.
The in situ valuation,
therefore, is a very weak method to use when valuing a mining company. It is
most useful when many of the above items aren't known or can't be estimated
accurately (such as in the case of an exploration company that has
established a resource but has not yet performed a feasibility study.)
The second
popular valuation method is the cash flow per share method. This method takes
a little more work than the in
situ method. First, one must determine the number of shares outstanding
and then divide this into the cash flow of the company. Cash flow, in this
case, is usually taken in the simple manner (Revenue minus non-GAAP cash
costs) rather than using GAAP operating cash flow. The resulting cash flow
ratio is then compared to the industry average for the sector to determine
whether the company is undervalued or overvalued. This method also has
significant weaknesses, however:
1. It does not
take into account the size of the company's resource. Mining companies have
discrete resources; they can only produce cash flow until the deposit is
mined out.
2. It does not
take into account a company's other assets and liabilities.
3. It does not
take into account the capital cost necessary to extract the resource.
4. It does not
take into account the time necessary to extract the resource, or the time
value of money.
5. It only
partially takes into account the capital structure of a company.
6. It is still
a relative valuation; i.e. it relies on multipliers derived from the valuations
of its peers.
7. Definitions
of cash costs (non-GAAP) vary notoriously amongst the different mining
companies.
8. It does not
take into account future expectations for the underlying commodity (i.e. -
the futures curve.)
9. It does not
take risk into account.
Thus the cash
flow method of valuation, while somewhat more useful than the in situ method, still does
not take into account many of the factors that need to be accounted for in a
valuation.
The most
accurate way to value a mining company, I believe, is to determine its net
asset value (NAV) based on discounted cash flows. All of the above weaknesses
in the in situ
and cash flow methods are addressed in the NAV method:
1. A company's
other assets and liabilities can be figured into the calculation of NAV.
2. Resource
size, capital and operational costs, recoveries, taxes, etc. are all
accounted for in the cash flow schedule.
3. Expectations
for future commodity price increases/decreases can be accounted for in the
cash flow schedule.
4. One is free
to add some (or even all) of the M&I resource into a mine life schedule
as one feels appropriate based upon other research. Even if this is done,
however, it is still discounted by the method since it adds cash flow at the
end of the mine life. In other words, proven resources still receive the
highest value.
5. The capital
structure of the company is fully taken into account, including cash flows
from option and warrant expiry.
6. It is an
absolute valuation; it does not rely upon empirical averages established by
peer groups.
7. Time value
of money and risk can be taken into account quantitatively via the discount
rate.
The NAV method does have some disadvantages, of course. Many precious metals
miners seem to continuously trade at a premium to NAV. This is certainly true
if one uses constant metal price assumptions in the valuations (this is most
simple and most common.) The reason that precious metals miners trade at a
premium to NAV is that the underlying commodity is in contango (i.e.
speculators expect the commodity price to rise in the future.) The solution,
however, is pretty simple. Depending on the intention of the valuation (e.g.
are we finding a buy point or a sell point?) one can use whatever commodity
price schedule they like and calculate future revenues based upon this
schedule. Some professional analysts use a version of the Black-Scholes
equation to calculate the "optionality" of each of the
company’s assets with respect to the variability of commodity prices.
Either way, it is not difficult to modify a NAV valuation to account for
future commodity price increases (or decreases), or to just accept that a
producing gold/silver miner will trade at a premium to NAV when using constant
current metals prices.
Another
deficiency of the NAV method is that it does not account for reinvestment of
future cash flows. This is certainly true, but it is also true of the other
valuation methods. There are simply too many unknowns in the mining industry
to be able to quantitatively account for future reinvestment with any degree
of accuracy. The NAV method is most useful in finding a minimum value (i.e. -
a buy point) of a company. When one is trying to determine a sell point, peer
comparisons and technical analysis should be used to supplement the NAV
method. None should be allowed to replace the NAV method, however, as it is
the most comprehensive method for taking into account all of the factors that
influence the value of a mining company. We are in the midst of a bull market
in commodities, and the rising commodity prices have masked what I believe to
be fundamentally flawed valuation methodologies. Investors would do well to
recognize that there is much more to mining than just a resource in the
ground, and that one year’s cash flow isn’t sufficient to value a
company with discrete resources.
Editor Note : this essay
was first published on World of Wall Street, author AceOfKY
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