Valuing an Exploration Company
January 20, 2006

We looked at how to value mining companies last week. Since these companies have real assets (mines), cash flow, and even perhaps earnings (if we're lucky), putting a value on them is fairly straightforward. Exploration companies are a completely different story.

Exploration companies don't have assets, cash flow or earnings. They typically only have a management team, sometimes a bit of cash, and one to several properties.

The cash will get spent, usually a lot quicker than anticipated. Their projects aren't assets: they are liabilities where the cash is going to get spent. That leaves us with management, and management is absolutely an exploration company's biggest asset -- if not its only asset. Promoters of these stocks will tell you their company's management has a superb track record, but the reality is that there aren't even enough mediocre management teams to run the thousands of exploration companies resident in Vancouver alone.

If an exploration company's only asset is management, how do we put a value on it?

Unfortunately the answer is "with difficulty". There is no easy way to put a value on exploration companies. It is easy to spot a really good deal when it stares you in the face, and it is equally simple to see when a stock is overvalued, but the nature of the business does not readily allow for valuations that one can use for short-term trading or "value investing".

Exploration is risky business. Buying exploration stocks is tantamount to gambling, and there are two safe bets when it comes to any exploration company. One: it will spend the money it has and two: it is highly unlikely that it will make a discovery. Yet I personally invest essentially all of my net worth in exploration stocks because I believe that there are ways to mitigate the risks and to shift the odds of success in my favor. Fortunately this part is straightforward.

The Nineties were rough for mining and there are now very few new exploration geologists graduating from school. To make things worse, most of the graduates of the past decade want desk jobs making their odds of discovering anything very slim.

When the major mining companies downsized their exploration efforts during the Nineties they not only curtailed exploration expenditures, they fired most of their geologists, closed regional offices and let many of their projects go. This caused a shift in exploration demographics -- the more innovative and experienced exploration professionals got together and formed new junior exploration companies, and picked up many of the projects the majors dropped. As a result, major mining companies now lack the human resources needed to explore for new ore deposits.

Still, mining is a depleting business -- the more you mine, the less you have left to mine and without exploration, mining will cease very rapidly. The mining companies know they need access to good exploration projects and, more importantly, good exploration teams. We know it too.

We need to look for companies whose managements have the ability to generate new exploration projects and the business acumen to joint venture those projects to major mining companies. A joint venture partnership allows the junior exploration company to use its intellectual capital to generate exploration ideas but the mining company's financial capital to test them. It is absurd to think that the average exploration company has but the remotest chance of making a discovery given how much money and time it takes. The only rational way to approach exploration is to marry the innovative skills of quirky, and often unsocial, exploration geologists with the balance sheets of mining companies in a win-win partnership.

In a typical deal the exploration company will generate an exploration idea, acquire the ground and perhaps spend a little bit of money to confirm that the geologic model it is proposing has merit by looking at soil geochemistry, geophysics and good old-fashioned geological mapping. Thereafter it will attempt to get a mining company to commit exploration funds to test its ideas in return for earning a percentage interest in the project. Typically the mining company can earn up to 70% to 80% by completing a bankable feasibility study or even financing the project to production.

This means that if our company is successful, we will end up owning 20% to 30% of a mine, whereas if it is unsuccessful it would have lost some time and a little bit of money because the mining company footed the heavy bills. This way an exploration company can use its limited cash resources to generate numerous projects, all funded by joint venture partners. It increases the life expectancy of the exploration company and by enabling it to generate and test more projects it also increases the probability that it will eventually be successful. I would much rather own 30% of a successful project than 100% of a dud.

There is something else that happens here. With this model the exploration company has to convince the geologists working for the mining company that its projects have merit. Not only do they need to have merit, they need to have sufficient merit to compete with the exploration projects generated internally by the mining company and all the other exploration projects being presented to the major by other juniors. This is a lot more difficult for a junior to do than to convince doctors, lawyers, dentists and taxi drivers that its projects are one drill hole away from changing the world (with all due respect to doctors, lawyers, dentists and taxi drivers).

I therefore avoid exploration companies that tell me they are going to spend millions of dollars drilling on their wholly owned projects, unless there are very, very, very compelling reasons.

We also have to look at what kind of projects the exploration company is looking for. You will be surprised how many times I have sat through presentations only to learn at the end that the geological target is unlikely to ever be economic or, if it might be, that it is likely to be so small that no major mining company will have any interest in it. The only thing we are interested in is making world-class discoveries.

This brings us to the next part: you should have access to a critical and well-seasoned exploration geologist. I am not a geologist yet I have to sift through geological evidence every day and decide whether to accept or reject the risk of exploration. I work very closely with a consulting geologist, and without access to a consultant I can trust it would be almost impossible to succeed in this business.

If an exploration company consistently comes up with new projects and continues to get exploration funding from major mining companies then this is a business I am interested in owning. I view stocks as fractional ownership in a company, not as trading cards. So if I find a business I would like to own I often watch it for several years, waiting for an opportune time to buy.

Now comes the question of how much we are prepared to pay for these things. While I cannot give you a formula with which you can put a dollar value on an exploration company, like we could with a mining company, the best I can do is tell you what I do with my own money, and why. My paid newsletter is essentially a weekly commentary of my personal investments, where I discuss the stocks I buy and sell, my reasoning and any updates on the stocks I own. I do not do stock promotions.

An archive of past issues is on my web site, and you can subscribe on a month-to-month basis and cancel at any time. See the Newsletter Section on www.paulvaneeden.com.

There will not be a commentary next week - I will be in Vancouver at the Cambridge House Resource Investment Conference and then at the Mineral Exploration Roundup.

Paul van Eeden

P.S. I may in future stop publishing these commentaries on Kitco so if you enjoy reading them I suggest you go to my website at http://www.paulvaneeden.com/commentary.php and register to get them by email. Rest assured that I do not sell or rent any of my subscribers' email addresses.

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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