Imagine you want to value a gold mining company “GOLDY Explorers”, which has 25 million ounces in resource estimates and 5 million ounces in reserves. How would you value GOLDY Explorers?
The answer lies in the question itself, since what you actually want to value are the 30 million ounces in resource/reserves. However, you cannot just multiply those with the market price for gold to get the market value, as the 30 million ounces of gold are still in the ground and they cannot be sold tomorrow.
In terms of absolute valuation you should focus on the net asset value (NAV) method. The more common discounted cash flows (DCF) method cannot be used to value a natural resource company because the basic assumption behind DCF valuation is that the underlying asset or firm would generate income indefinitely and there will be a terminal value associated with the same. However, this is not the case with GOLDY, as an investor/buyer would only pay the monetary equivalent of the current assets (NAV) and will not assume the firm to be a “going concern” given that the underlying asset (gold in this case) is a finite resource.
The valuation of GOLDY would grossly depend upon 4 main factors:
Stage of Production: We need to look at the stage GOLDY is in, which can be exploration, mining or production. Resource/ reserve estimates of GOLDY can be measured with higher certainty if GOLDY is in production stage than if it is in mining or in exploration stage. And, as the famous Wall Street quote goes, “the market doesn’t value uncertainty”, so GOLDY is worth more per ounce if it is in production than if it is in mining stage.
Actual time to production: The closer GOLDY is to production, the higher the company is valued per ounce by the investors. Even if two companies are in the same mining stage, the one that is closer to production will be worth more per ounce, as the market will use a lower discount rate. For example, if GOLDY is supposed to get into production in 2013 and another firm called “Lazy Gold” in 2015, one can easily say that cash flow for firm GOLDY will start one year earlier so the discount rate used would be lower.
Resource estimates: The value of a firm is not only dependent upon amount of resource and reserve estimates but also the type of estimates. There are 3 types of estimates:
a) Inferred resources
b) Measured and Indicated resources:
c) Proven & probable reserves
As a firm moves from closer to production, the amount of proven & probable reserves increases at the expense of indicated and inferred resources. The market puts a higher per ounce valuation on proven & probable reserves than on inferred and indicated resources. A mining company would have higher proportion of proven & probable estimates than an exploration firm, for example.
Price of resource (gold in this case): Although GOLDY is not currently selling gold, its value would be directly proportional to the price of gold as market expects them to sell gold at a higher price in the future –even if it is 10 years from now-. In fact, if you were to place the price chart of GOLDY and the one for gold side by side, you would find a very strong correlation.
This is why many people see big mining companies as a “macro call”. And this is why in many buy-side firms it is the senior portfolio manager who makes the calls on the Rio Tintos and BHP Billitons of this world, just as they do with banks, for example.
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Interesting insight. I was under the impression that the DCF was solely based on the CashFlows for a particular year and was independent of the stage the company was in. In case the company was operating in its later stages it would have a low terminal value. Overall the valuation would not be impacted by the stage of operation of the company.
I would say it is more of a terminology issue. A NAV valuation is a DCF valuation. The key point is that reserves are a wasting asset and do not have a terminal value.
I would have liked to have seen a reference to the “option value” of future resources.