Valuation of a mining company

By | September 3, 2011

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.

Mining jargon:
Aeromagnetic – measurement of the strength and orientation of the earth’s magnetic field acquired using an airborne instrument
Ag – the symbol for silver (Argentium) on the Periodic Table
Anomaly – an area which exploration has shown to be different from the surrounding area or region
Assay – a test to determine the level of a particular element in a sample
Au – the symbol for gold (Aurum) on the Periodic Table
Backwardation – the current or spot price for a commodity is higher than the price that will be paid for delivery at some defined time in the future (the reverse of “contango”)
CIL – Carbon-in-leach – a process for recovering gold from rock where the gold is dissolved by cyanide in the same tank as it is absorbed onto carbon
CIP – Carbon-in-pulp – a process of recovering gold from rock where the gold is dissolved by cyanide in a series of tanks, and the carbon onto which the gold is absorbed is passed in a counter-current direction
Concentrate – the product of a treatment plant by which the abundance of a particular mineral species is upgraded above the abundance in the ore which is fed into the plant
Contango – the current or spot price for a commodity is lower than the price that will be paid for delivery at some defined time in the future (the reverse of “backwardation”)
Cu – the symbol for copper (Cuprum) on the Periodic Table
Deduction units – The % deducted from concentrate grades to calculate the metal paid for by a smelter. e.g. copper conc’s typically deduct 1.1 units so a concentrate grading 28% copper would be paid as grading 26.9% copper (effective 96%)
Diamond drilling – a method of drilling in which a cylinder of rock is recovered by drilling with a diamond-impregnated bit
EL – Exploration Licence – a tenement granted by the relevant authority which enables an entity to explore for a specified suite of minerals
ELA – Exploration Licence Application – an application for a tenement that has yet to be granted by the relevant authority
EP – Exploration Permit – see EL
EPA – Exploration Permit application – see ELA
Electrowinning (EW) – the recovery of metal from a solution by electrolysis (also see solvent extraction)
Feasibility study – an assessment of the legal, environmental, social, cultural heritage and governmental aspects of a proposed project as well as the technical aspects of mining, processing and marketing the product is coupled with financial analysis to determine the viability of the project
Flotation – a wet chemistry process by which particular minerals are induced to become attached to bubbles and to float, while other minerals sink
Footwall – the rock which lies below the ore
g – gram – a measure of weight
g/t – gram per tonne – the grade of a precious metal deposit
goaf – the caved area behind a longwall. See “Longwall”
Grade – the level of a valuable mineral or element in a rock
Gravity survey – the measurement of the gravitational field of the earth
Gravity concentration – using the different densities of minerals to separate valuable minerals from rock, or from each other
Grinding – the process of reducing rock to flour-sized particles for further processing
ha – hectare – an area 100m by 100m
Hanging wall – the rock which lies above ore
Heap leach – To dissolve minerals or metals out of an ore heap
using chemicals. During heap leaching of gold, a cyanide solution percolates through crushed ore heaped on an impervious pad or base pads.
JORC Code – Joint Ore Reserve Committee Code – sets the standard for reporting resources and ore reserves
Joint Venture – JV – an agreement to operate an area, either in exploration or production, where each party pays an agreed proportion of the costs and receives an agreed proportion of the product
Kriging – a geostatistical method of interpolation which predicts unknown values from data observed at known locations, and is used to determine ore resources and ore reserves
lb – a measure of weight in the Imperial System – equal to 454 grams
Leaching – a hydrometallurgical process by which the valuable metals are removed from the rock
Lode – the body of ore or valuable mineral, commonly tabular in shape
Longwall – Employs a rotation drum, which is pulled mechanically back and forth across a face of coal that is usually around 200m wide. The loosened coal falls onto a conveyor for removal from the mine. Longwalls are operated in panels up to 4km long. The area behind a longwall is allowed to cave and is termed the “goaf”.
Magnetic survey – measurement of the strength and orientation of the earth’s magnetic field
Metallurgical recovery – commonly expressed as a percentage, it is the proportion of the valuable mineral or element that is recovered by the processing plant
Ni – the symbol for nickel on the Periodic Table
Open Stope – see “Stope”
Ore – mineral bearing rock which can be mined and treated profitably under the current economic conditions, or those conditions which are deemed to be reasonable. The term “ore” should not be used until a feasibility study is undertaken to generate a reserve.
Ore reserve – the economically mineable part of an Indicated or Measured Resource. An ore reserve allows for losses which may arise from an inability to extract the entire resource, and for dilution by material which doesn’t contain the valuable component. A feasibility study assessing the legal, environmental, social, cultural heritage and
governmental aspects of the project as well as the technical aspects of mining, processing and marketing is required, coupled with financial analysis to confirm the viability of the project, prior to reporting a reserve
Ounce (Troy) – 31.1034 grams – a measure of the weight of a precious metal
Payable metal – see deduction units
Pb – the symbol for lead (from Plumbum) on the Periodic Table
Percussion drilling – a method of drilling where a drill bit is turned on the end of a drill string and also hammers up and down, to drill a hole and generate chips of rock from the formations or strata penetrated by the bit
Parts per million – ppm – a measure of the grade of a precious metal deposit, or used in reporting geochemical sample results – equal to g/t
Penalties – Penalties are imposed for undesirable elements contained in concentrate’s that increase the smelter’s cost. There are no standard ‘rejection limits’ for the penalty elements, however ‘dirtier’ concentrates can only be sold for lower returns than cleaner concentrates. A short list of common penalty elements: antimony, arsenic, fluorine, mercury and zinc or lead in copper conc’s.
Price participation (pp) – The price participation mechanism increases the TC as the metal price increase above, and reduces the TC as the price decreases below and agreed base price. This allows smelters to participate in rises/falls in the metal prices (other than adjusting TC’s) – also see Treatment Charges.
Refining Charge (RC) – The price paid by mining companies to smelters for refining the contained precious metals (and copper) in their concentrate’s to produce a payable metal. The refining charge is based on the payable metal content (after deductions).
Refractory ore – an ore which is difficult to treat by simple, conventional or low-cost methods. In gold ore, this commonly refers to the gold mineralisation being contained in a silica or sulphide, where it is not amenable to cyanide treatment.
Reserve – see Ore Reserve
Resource – an in-situ mineral deposit from which valuable minerals may be recovered. Under the JORC Code there are Inferred, Indicated and Measured resources, depending on the level of information available, with “Inferred” the least known, and “Measured” offering the greatest level of confidence. On completion of a positive feasibility study, the Indicated Resource will generate a Probable Reserve, and the Measured Resource will generate a Proven Reserve.
Reverse Circulation (RC) drilling – a method of percussion drilling which minimises contamination of the sample
Rotary Air Blast (RAB) drilling – a method of drilling where the drilling tool is turned in the hole without any percussive or hammer effect
Solvent Extraction/Electro Winning (SXEW) – a type of heap leaching and subsequent processing used for secondary copper ores whereby the oxidized copper minerals are taken into solution. The copper-bearing solution is processed to recover metallic copper from the solution electrolytically. See also electrowinning.
Stockpile – material of value mined and stored for future treatment
Stope – The underground excavation within the orebody where the main production takes place. Depending on the orebody qualities, stope’s can range from 5kt to 2mt.
t – tonne – a measure of weight equal to 1,000kg, or 2,204 lbs
Tailings – the material remaining after processing has removed the valuable minerals or material
Treatment charge (TC) – The charge paid by a mining company to have their concentrate treated through a smelting to produce saleable metal. This is quoted in US$/t of concentrate.
tpa – tonnes per annum
U – the symbol for uranium.
US$ – United States dollars
Waste – material other than ore which is removed during the mining process
Yellowcake – U3O8 – the oxide of uranium commonly traded.
Uranium quoted as US$/lb is US$/lb of U3O8.
Zn – the symbol for zinc (Zincum) on the Periodic Table

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4 thoughts on “Valuation of a mining company

  1. Rahul Pratap Singh

    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.

  2. Karim

    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.

  3. Sam

    “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.” I dont think the time plays any role for the discount rate. -It is the risk that does. The valuation for Lazy Gold will be lower due to the fact that cash flows in two years a less than they are today.

  4. Pingback: Proven Cash Flow Method. |

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