How to Value a Mining Stock
January 16, 2006
I received an interesting question
about company valuations from one of my newsletter subscribers that
I thought I would address as a Commentary. It is a multi-part question
that will take more than one Commentary to address; this week is
part one: Valuing Mining Stocks.
Mining is a finite business. Mineral
deposits contain a certain amount of ore and when that ore is mined
out the deposit is depleted, no matter what you do or wish.
That is in stark contrast to say,
an auto parts manufacturer, who can adapt to new demands and specification
changes and (hopefully) stay in business for many decades. When
you value an auto parts company, you can compare the company's price
to earnings, price to cash flow, operating margin and net profit
margin (among other things) to the company's peers to assess whether
the stock in question is relatively cheap, or relatively expensive.
You can also get a sense of whether the stock is cheap or expensive
in an absolute sense by looking at the book value per share and
comparing things like the profit margin and dividend rate to prevailing
interest rates. But, embedded in all this (except book value per
share) is the implicit assumption that the earnings and cash flow
are for all intents and purposes infinite. When you are dealing
with a business that can be reasonably expected to continue in a
similar fashion for many decades, earnings per share, cash flow
per share, dividend rate, etc. are meaningful. That is not the case
with mining.
Take a hypothetical mining company
that has only one mine as an example. Let us assume that mine is
going to produce for another five years before the ore will be depleted.
Now, let us say that the company's price to earnings ratio is ten.
A hypothetical auto parts manufacturer also has a price to earnings
ratio of ten. Based on just this one metric, we cannot differentiate
between the two stocks. Let us also assume that the prevailing ten-year
interest rate is five percent.
This means that you can invest
your money in a ten-year bond and earn five percent per year while
taking relatively little risk (other than the risk of interest rates
rising, which could negatively impact all the investments under
consideration and is therefore not considered).
The auto parts manufacturer has
a price to earnings ratio of ten. That means for every dollar's
worth of stock you buy, you expect to earn ten cents, or ten percent,
in earnings. It does not really matter for our purposes whether
those earnings are retained by the company or paid out as a dividend
since, either way, the earnings accrue to the benefit of shareholders.
Furthermore, you can reasonably assume that the auto parts manufacturer
is going to be in business for several more decades and, because
you have done lots of due diligence, you can also assume that the
future earnings are likely to be the same as the current earnings.
So, if you buy the auto parts stock, you will earn ten percent per
year as opposed to five percent on your bonds. The auto parts stock
is probably riskier than a bond; however, if you can make twice
as much money it might be tempting.
Then you look at the mining stock
and notice that it, too, has a price to earnings ratio of ten and,
therefore, you can also make ten percent a year if you bought that
stock. But you would be wrong. The mining company's mine only has
a five-year life ahead of it. So, if it has a price to earnings
ratio of ten it means that for every dollar of stock you buy you
get ten cents in earnings. But the earnings are only going to last
another five years, so your total earnings per dollar of cost will
only be fifty cents -- half of what you paid for the stock -- and
then the mine is depleted. That's why comparing a mining stock to
other investment opportunities on the basis of price to earnings,
price to cash flow, or dividend yield is complete nonsense. It is
just as futile to compare mining stocks to each other based on these
metrics because mining companies have different mine lives in their
operations.
The only reasonable way to evaluate
a mining company is to look at the net present value of the potential
future cash flow, discounted at an appropriate discount rate. You
have to take into account not just the cash flow that the mine(s)
is generating, but also sustaining capital costs (including future
exploration and development costs) associated with keeping the mine
in production. Assuming you can derive a suitable cash flow model
for each mine that a company owns you can then calculate the net
present value of future cash flow by using an appropriate discount
rate to represent the geological, political, social and financial
risks. If you sum all the net present values together, add any other
assets on the balance sheet and subtract any debt, you will arrive
at the net asset value per share. In a rational world you would
expect to pay no more for a mining stock than its net asset value
per share -- how do you expect to make money if you consistently
pay more for stocks than what they are worth? But, in the real world,
mining stocks almost always trade for more than the net asset value
of their constituent mines, and for a good reason.
Mining stocks also offer leverage
to commodity prices. Take a gold mining company as an example. Assume
we have a company that mines gold for a total cost of $400 an ounce,
and let us pretend the gold price is $500 an ounce. The net present
value of the mine would be calculated based on the $100 margin.
If the gold price increases by 20% to $600 an ounce the net present
value of the mine will double, since the margin would now be $200
an ounce. Thus the value of the company increased five times more
than the increase in the gold price. Most people buy mining stocks
because of this leverage.
What should be immediately evident
is that if you pay more for mining stocks than what they are worth,
on the speculation that the price of the underlying commodity will
increase, you are merely gambling on the commodity price. Fortunately
there is a way to quantify the premium that one should pay for a
mining stock to incorporate the leverage it has to the underlying
commodity price. There is a formula called the Black-Scholes Model
that can be used to calculate the "option" value of a mining stock.
What should be done is to calculate the discounted net present value
of the all the company's mines and then add the "option value" of
the mines as calculated by the Black Sholes formula to obtain a
more realistic asset value per share. By adding the optionality
of mining shares to the net present value of the mines themselves
we can account for the fact that mining shares trade at a premium
to their net asset value because of their leverage to the underlying
commodities.
If you calculate the net asset
value of a mining stock as described above you will get a result
that can be used to compare different mining companies to each other,
and mining companies to investments in other sectors. Unfortunately,
very few mining analysts employ the Black Sholes model to calculate
mining net asset values, so for most people buying mining stocks
really comes down to blind speculation on commodity prices.
Next week we will look at exploration
companies, which are much more subjective to analyze than mining
companies.
Paul van Eeden
P.S. I may in future stop publishing
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Paul van Eeden works primarily to find investments for his
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