Valuing Mining Stocks - In Defense Of Net Asset Value

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From the Archives : Originally published February 28th, 2009
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Category : Gold University

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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