Valuation Methods

Question 1

What are the two major differences between mining valuation and conventional valuation for run-of-the-mill companies?

Answer 1

There are two major differences between mining valuation and conventional valuation for run-of-the-mill companies:

1) The discount rate;
2) Zero terminal value.

These two are reflected in the DCF driven valuation metric for miners – Net Asset Value or NAV.

Question 2

In valuating mining companies, what do miners not use? What do they use instead?

Answer 2

Mining companies do not use the Capital Asset Pricing Model that is common for most DCFs – especially gold companies. Mining net present value will use a standard discount rate with a floor discount rate commonly used for the mined commodity plus a risk factor.

Question 3

Define Beta

Answer 3

CAPM = Rf + B(Rf – Rf + Country Risk)

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns.

Question 4

Why is gold the best example for why we use NAV instead of CAPM?

Answer 4

Gold is the best example for why this is used in place of CAPM – the yellow metal has a zero or negative beta due to its role as a safe haven asset. Gold and Platinum Group Metals (PGM) will have a floor discount rate of 5%, which will be adjusted upwards for political risk and stage of development (the difficulty of the geography is already baked into costs of extraction in the projected cash flows). Base or industrial metals (copper, tin and zinc) have the same rule – except the floor is 7 or 8%.

Question 5

Define terminal value

Answer 5

Terminal value (TV) represents all future cash flows in an asset valuation model. This allows models to reflect returns that will occur so far in the future that they are nearly impossible to forecast

Question 6

Why is there no terminal value for the NAV model?

Answer 6

There is also no terminal value for the NAV model (“normal” companies will assign a terminal value based on an exit multiple and some will use a perpetuity value for the business past the forecast period) because the idea is that the mine is operated until it is depleted. There will be option value for expansion embedded in the price, as good properties will see the resource convert into reserve as more data comes out, elongating mine life (producing miners tend to trade above their NAV to account for this option value).

Question 7

What are the two key distinctions in mining valuations?

Answer 7

Key to remember is that these two distinctions are for mining only, and not necessarily metals. Net Asset Value is for extraction industries (mining and oil exploration & production) where there is a finite resource – steel, smelting and refining are EV/EBITDA garbage-in, garbage-out companies just like Lululemon.

Question 8

To calculate the NAV of a mine, what first must be calculated? Which factors must be considered?

Answer 8

First the Net Present Value (NPV) of each individual mine in the miner’s portfolio needs to be calculated. The NPVs are calculated considering these factors:

Commodity price over the mine life

Development costs

Labour

Fuel

Discount rate

Question 9

First the Net Present Value (NPV) of each individual mine in the miner’s portfolio needs to be calculated. The NPVs are calculated considering these factors: Define commodity price over the mine life

Answer 9

Commodity price over the mine life – If the project is a gold mine, a gold price that the company will receive must be assumed. Usually, a long-term price will be assumed, but if there are strong views on price and a short life, more granularity can be layered into the model. Depending on the company’s hedging strategy, a hedge can ensure that the price received will be exactly the one in the model.

Question 10

First the Net Present Value (NPV) of each individual mine in the miner’s portfolio needs to be calculated. The NPVs are calculated considering these factors: Define development costs

Answer 10

Development costs – If the mine is not already producing ore, preparing the asset for extraction is costly. The total cost figure depends on various factors, including the size of the mine, the geology, refining options and distance to market. Depending on where the majority of the resource is and the subsequent configuration of the planned mine (cut and fill, room and pillar – open pit or underground etc.), the variance can be enormous.

Purchases of heavy equipment (Caterpillar, Komatsu/Joy Global) will be required as trucks and excavators do much of the heavy lifting (literally). During mining booms, purchase costs will be high as heavy equipment OEMs and their dealers (Finning International/Toromont) have large backlogs to service. During mining busts, used equipment may be purchased at a discount and product servicing may be moved in-house.

For development costs, labour is usually in the currency of the mine’s domicile. However, the purchase of material and equipment to construct the mine is usually in US$ and may be hedged away.

Question 11

First the Net Present Value (NPV) of each individual mine in the miner’s portfolio needs to be calculated. The NPVs are calculated considering these factors: Define labour

Answer 11

Labour – Mining continues to be a relatively dangerous job compared to working in an office and miners require fair compensation. Depending on the jurisdiction of the mine, labour costs can vary greatly. A Canadian mine with safety best practices, low wealth inequality and strong labour laws will have higher labour costs than a mine in a developing country. Labour and other operating expenses can usually be FX hedged if predictable. In an emerging market, labour volatility and unrest will be higher, and the possibility of strikes and other unforeseen events may make assumptions unreliable (although this is accounted for in the discount rate instead of here).

Question 12

First the Net Present Value (NPV) of each individual mine in the miner’s portfolio needs to be calculated. The NPVs are calculated considering these factors: Define fuel

Answer 12

Fuel – The image of Caterpillar trucks hauling ore tonnage back and forth from the mine is well known. These dump trucks require enormous amounts of diesel. Much of the other machinery on the mine sites also consume significant fuel volumes, making fuel a mainstay in mining company financial statements. Fuel can be hedged, but hedging policy needs to be consistent with the mined resource hedging strategy, otherwise the mining company may be taking on inadvertent positions.

Hedging oil (usually Brent) is cheaper than hedging diesel directly, but comes with basis risk. We illustrate this with a mining company that is long oil (pays a certain amount to receive x amount of Brent crude), when it requires diesel. If a fall in other crude derivatives (gasoline, kerosene) drag down the price of crude but diesel demand rises, the company may receive cheaper oil and must purchase more expensive diesel.

Question 13

First the Net Present Value (NPV) of each individual mine in the miner’s portfolio needs to be calculated. The NPVs are calculated considering these factors: Define discount rate

Answer 13

Discount Rate – This will depend on the risk of the project and is the function of various risk factors. Compared to other industries, mining is associated with a wide range of country risk premiums despite the corporate being domiciled in Vancouver or Toronto. Chile, Canada and Australia are the gold standards for being low-risk, stable jurisdictions and have strong and tested legal frameworks. Operating a mine in Russia will come with substantial amounts of political risk due to weaker remedies for breach and unfamiliar business practices. The rest of the risk is project risk, which considers factors including, but not limited to, reserves (grade, tonnage, life of mine), configuration, decommissioning liabilities, and labour relations.

Question 14

How do you value the mining corporation as a whole?

Answer 14

The value of the actual corporate (NAV) is the sum of the mine NPVs (the cash flows multipled by the discount factors for each mining project) and adjusting for other capital structure components. An analyst would sum up the NPV of all the mines in the portfolio, subtract debt and debt-like structures and add cash, the value of the hedge book and investments.

Question 15

Once the NAV is known, which metrics are commonly used for valuation in metals & mining?

Answer 15

Enterprise Value/EBITDA

Price/Net Asset Value

Price to Cash Flow – T+1, T+2

Other valuation metrics include EV/P1 Reserve, EV/P2 Reserve, and EV/Resource.

Question 16

Define Enterprise Value

Answer 16

The Enterprise Value, or EV for short, is a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization.

EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

Question 17

Define EBITDA

Answer 17

Earnings before interest, tax, depreciation and amortization (EBITDA) is a measure of a company’s operating performance. Essentially, it’s a way to evaluate a company’s performance without having to factor in financing decisions, accounting decisions or tax environments.

Question 18

When is EV/EBITDA primarily used?

Answer 18

EV/EBITDA is primarily used for large, stable and diversified miners such as BHP Billiton, Rio Tinto, Glencore and Vale. For these companies, mining project life is well defined and cash flows are relatively predictable. If one mine goes under, this will not have an outsized effect on EBITDA because there are several mines across several commodities being extracted concurrently.

Question 19

Why is EV/EBITDA not necessarily meaningful for junior and intermediate miners?

Answer 19

Additionally, only senior gold producers and large diversified miners can issue corporate level debt, so enterprise value is not necessarily a meaningful figure for junior and intermediate miners. Junior and intermediate miners can sometimes tap into high yield debt markets if they have sufficient size and if debt capital markets are open to them, but usually will need to issue equity or equity-linked notes (convertible bonds, mandatory convertibles). Corporate banks may offer bridge financing between the time when the equity or equity-linked notes are issued and announcement.

Question 20

When is P/NAV more popular?

Answer 20

P/NAV is more popular for miners that focus on one or two commodities – it ascribes value given to each ounce of gold or whatever the relevant unit metric is for the metal. Where the P/NAV multiple trades at is dependent on how de-risked or unrisked the mining asset is (when the next stage is reached, the profits become less uncertain). With each stage of development, the P/NAV multiple will trade higher – from feasibility (preliminary economic assessment, pre-feasibility & feasibility) to construction to production to project expansion.

Question 21

Who is generally evaluated on a P/NAV basis?

Answer 21

Most explorers, developers and junior producers will be evaluated on P/NAV. The P/NAV for explorers can be 0.3-0.5x, so that there is a healthy risk premium embedded.

Question 22

What ways do equity analysts quote NAV?

Answer 22

Often, equity analysts will quote a risked NAV, unrisked NAV and bluesky NAV. A risked asset means it has not secured financing or there is some other impediment to production. Unrisked assets will trade higher, as alluded to above. Bluesky NAVs are unrisked NAVs given ideal commodity prices and FX and are best ignored by a prudent analyst.

Question 23

When is Price to Cashflow – T+1, T+2 appropriate?

Answer 23

Price/Cash Flow is the second most popular metric for most non-global, diversified miners. Usually Price/Cash Flow is looked at from a one year out and two year out basis. P/CF will also heavily consider the country risk for the miner, as assets in developed nations are more likely to see work stoppages due to labor shortages, strikes and other unforeseen production delays.

Question 24

Define total cash costs

Answer 24

“Direct” costs to extract an ounce of gold which are usually classified as operating expenses (mining and processing, but only cash expenses). All of these measures will fall as production ramps up as many fixed costs are spread out over the production and processing and mining benefit from economies of scale.

Question 25

Define All-In Sustaining Cash Costs

Answer 25

Sustaining capital expenditures are added to total cash costs as a more accurate measure of the cost of extraction as without the sustaining capex production would cease.

Question 26

Define All-in Costs

Answer 26

Considers all the costs throughout the mining cycle.

Question 27

Define byproduct credits

Answer 27

Depending on the gold deposit, a ton of gold ore will usually have other commercial minerals (as well as punitive minerals which are costly to extract and have little commercial value) – gold ore usually will have silver (copper ore will often have gold), so when these are taken out during processing they can be sold off, improving the economics of the mine. Often, AISC are shown on a gold only basis as well as net of byproducts, which will lower the AISC as the byproduct credit is subtracted from the cost.

There is a similar concept in natural gas extraction in oil and gas, as liquids rich gas can lower the breakeven of production, to the point where you have “negative breakevens”. The silver production can be sold off in a streaming agreement as a funding source.

Question 28

Define Byproduct vs Coproduct

Answer 28

When primary production is split between two metals, it does not make sense to have byproduct costs with one metal in focus, or breakeven economics will always be positive. For companies such as Silver Standard or Hecla Mining, coproduct costs are used for investment decisions with a blended gold-silver price in the ore.

Question 29

Define gold equivalent production

Answer 29

The company evaluates the amount of byproduct (mostly silver) mined, and the value is divided by the price of gold to give an equivalent number of ounces. Of course, depending on the price of those commodities vs gold, this number fluctuates.

Question 30

What considerations should be looked at that shine light on the creditworthiness before looking at capital structure and where each source of capital falls in pecking order?

Answer 30

Scale

Diversification

Position on cost curve

Consumers

Geography and political environment

Reserves

Question 31

What considerations should be looked at that shine light on the creditworthiness before looking at capital structure and where each source of capital falls in pecking order? Define scale

Answer 31

Scale – A BHP Billiton with vast operations, global knowledge and know-how, and opportunistic logistics network is going to be better positioned than a junior pure play. When things go poorly, asset sales are possible and when things are going well, opportunities to realize value on weak assets via spin-off are possible.

Question 32

What considerations should be looked at that shine light on the creditworthiness before looking at capital structure and where each source of capital falls in pecking order? Define diversification

Answer 32

Diversification – Having a variety of outputs smooths cash flow volatility, and better performing metals in the portfolio can help sustain a lossmaking business unit when it is at a cost above the commodity price, but should be well positioned after consolidation. As with energy, some mines are more difficult to stall for technical or legal reasons. If every business unit is experiencing weakness in the underlying commodity, this may not save the company.

Question 33

What considerations should be looked at that shine light on the creditworthiness before looking at capital structure and where each source of capital falls in pecking order? Define position on cost curve

Answer 33

Position on Cost Curve – A company that is lower on the cost curve has a much larger buffer for the commodity price to fall before it fails to meet return hurdles. A company very low on the cost curve has much more operational flexibility, and in markets where there is significant share (BHP and Rio in Iron Ore), they can aggressively price and increase output in a time of oversupply, forcing consolidation and a new equilibrium.

Question 34

What considerations should be looked at that shine light on the creditworthiness before looking at capital structure and where each source of capital falls in pecking order? Define consumers

Answer 34

Consumers – A diversity of end user demand is important. Dependence on China and the subsequent shift in economic direction has been sobering for many miners.

Question 35

What considerations should be looked at that shine light on the creditworthiness before looking at capital structure and where each source of capital falls in pecking order? Define geography and political environment

Answer 35

Geography and Political Environment – Although listed in Toronto and Vancouver (for a strong legal framework and favorable tax regime), many mining assets are in politically unstable jurisdictions. Even in Canada and the US, mines are rife with unionism, strikes, political wrangling and environmental concerns. Having profitable mines in developing countries without strong legal frameworks may result in problems limited to bickering and uncertainty to full expropriation. From a credit perspective, a low cost, long-life mine in Canada would be ideal.

Question 36

What considerations should be looked at that shine light on the creditworthiness before looking at capital structure and where each source of capital falls in pecking order? Define reserves

Answer 36

Reserves – The absolute number for reserve size is important. The longer the life of the mine (reserves vs production), the higher the grade of the ore and the lower the cost of separating the saleable commodity speaks to the quality of the reserve. Similar to energy, the cost of developing undeveloped reserves is a relevant factor.