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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
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
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
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
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
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
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