Wednesday, 8 September 2010

Gold mining valuation metrics and its limitations

When comparing gold mining companies, operational key elements, such as cash cost per ounce produced are a key metric. "Cash cost per ounce produced" is a non-GAAP performance measure which provides an indication of the mining and processing efficiency. There is an industry definition called the “Gold Institute Gold Cost Standard” of what is included and how it needs to be calculated. See page 4 of following reference: Gold Mine Cost Report – Q3 2010.

That publication gives a sound idea of how different cash cost can possibly be among operating gold mines. It also points out the continuous rise in cash costs. This has recently been discussed by Scott Wright a senior mining analyst working at Zeal. See: Gold mining margins.

The total amount of investments is of primary importance, but cannot be used as a metric for comparison since capital expenditure tends to dramatically vary over time. Capital expenditure is also quite varied with regard to its purpose:
  • Mining maintenance and scheduled extension to gain access to well localized ore veins;
  • On site development to study or optimize future extensions of the mining operations within the concession area;
  • Purchase and installation of equipment to increase or improve metal recovery from the ore;
  • Purchase of metallurgic equipment to refine the doré (gold rich metal ingots);
  • Exploration work on new ‘greenfield’ concessions aiming to study the feasibility for a new mining development;
  • Development of a potential future mining site, leading it through the permitting stages: environmental impact study, mining plan of operations and its economic viability (including road access and power access or generation), financing of mining development, etc.;
  • Financial investments either through partnership or take over of explorers, developers or junior producers.
This shortlist clearly shows that the purpose of these investments can be on a different playing field: improving the margin, extending existing mine life of a specific site or ensuring the future viability and profitability of the mining enterprise. This last purpose clearly links to assets rather than to the operational side of business.

Apart from operational key elements, it is indeed fair to compare assets: what are the reserves and the resources for these mining companies (producers) or those developers and explorers? This is what I will further discuss in this posting.

A key metric widely used is the market capitalization per ounce of reserves or per ounce of resources. The amounts of reserves and resources are reported by mining companies in their annual reports for all of their concessions and operational mines. Shares issued, warrants or options and their strike price are found on the passive side of the company’s balance sheet. So market capitalization is easily obtained as the product of share price and number of shares issued and it is generally included in share price listings.

To save you the hassle of making all those calculations, this metric is available on some websites such as (Registered user can make multiple listings.)

For US listed mining companies, the metric is in US$/oz, for companies listed in other countries and on different exchanges, the valuation is made in local currency: AUD/Oz, CAD/Oz but the USD/Oz equivalent is calculated using the exchange rate for that day. So could you just pick the cheaper shares, with a low market cap per ounce and hope for a juicy return?

This is less easy than it seems at first sight, unfortunately. Because of market capitalization changing rapidly with the share price, it doesn’t really make sense to add an extended list here (provided that copyright would allow it). Just a few transcribed data (valid by 27 Aug. 2010) can do to illustrate the caveats of using this metric.
(*) valid for the share price and market capitalisation on 27 August 2010
The first listed ‘Hecla Mining’ seems to trade very expensively, far above the current market price of gold. Moreover the resources (non-producing mining concessions) are fairly expensive as well. Are those data correct? Of course, but Hecla Mining happens to be a silver miner (I chose one without the word SILVER in the company name). So what you see here is the valuation of the gold (a secondary product) as if the silver were not there: quite a distorted view.

Those familiar with big cap mining immediately knew Freeport McMoran is a very similar case. Gold accounts for roughly a quarter of the revenue of this copper and gold miner. The copper price being more volatile, dependent on industrial demand and rather prone to speculation, the percentage revenue from gold tends to vary a little. Any hedging practice for either one of the two outputs can further alter that percentage revenue over time.

For Kinross, a low cash cost miner, you pay about US$ 322 per ounce of reserves, which is considered on the cheap side. The weak point of Kinross is the amount of resources, not very abundant as compared to reserves. The intended take-over of ‘Red back Resources’ by Kinross primarily aims at replenishing the Kinross resource base.

Gold Fields has plenty of resources as compared to the reserves and trades at a quite lower ratio of Market Cap/Ounce reserves. Harmony Gold is even over three times cheaper than Gold Fields and resources are valued at a ridiculous 6.15$/Oz. At this lower valuation end, we find two mining companies with mainly South African activities, operating at well above average cash costs (Gold Fields) or cash costs among the upper quartile of producing mine sites (Harmony). This makes clear the difference: reserves are to be valued considering the production margin. With gold at roughly $1,250/oz, producing 400,000 ounces at a very high cash cost of $1000/Oz yields the same $ 100M cash flow as producing 100,000 ounces at a fairly exceptional $250/Oz. So should we rather value market capitalization against the potential cash flow? A rather problematic exercise though: imagine in both cases an increase of mining cash costs of 10% at constant gold price. The former mine sees its earnings dwindle, whereas the latter would hardly feel the pain… With cash costs getting out of control, the reserve base of a mining company might actually be revised downwards: a mining site might be put ‘on care and maintenance’ if cash costs approach or exceed revenues. Related ‘reserves’ would then disqualify to ‘resources’.

Last two companies in our little table have no data listed for reserves, but resources are valued rather on the cheap side. How come? Those are explorers without operating mines. (In fact I chose the two among a set of explorer picks of Bob Moriarty.)

Reserves versus Resources
How are resources to be valued as compared to reserves? Well first of all: both come in several categories: reserves are qualified as ‘proven’ or ‘probable’. Resources are qualified as ‘measured’, ‘indicated’ or ‘inferred’, depending on the degree of certainty as derived from drilling results. Moreover ‘resources’ really means ‘gold in the ground’. You’re not sure it is ever going to be mined. A lot depends on the ability of the management of the explorer/developer to get it through the permitting stages, source in mining expertise or conclude a partnership, assure financing…

Once these procedures are concluded, ‘resources’ now qualify as ‘reserves’. Unless the company is taken over before, the market cap will rise as production commences, but depending on the financial expertise of management, the number of shares may just double by capital raises and warrant conversion or explode by an order of magnitude… As a shareholder you are either rewarded or wiped out.

Discussion of the ranking table
It is quite cumbersome to deal with two rankings:
  • one with the very meaningful "Market cap/Reserves" is not applicable to explorers,
  • another less meaningful lists "Market cap/Resources". 
The latter then disregards the reserves of operational mines being exploited.
Moreover both metrics leave out any secondary production: ounces of gold means just that: it doesn't include the 'gold-equivalent' of any copper, silver or other metal generating a secondary revenue stream. Yet better informaton is available:

When looking into data sheets of individual mining enterprises, it is possible to distinguish among production sites, secondary materials mined and to obtain the total estimated in-situ value of reserves and resources. Market cap is then simply expressed as a percentage of that in-situ value. It's a straight forward calculation. Just a pity it is missing from the main ranking.

More similar papers are linked to in the top section of the list of blog articles.

1 comment:

  1. It is really a very nice posting. I am greatly impressed after reading it. Thanks
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