Valuation of Gold Mining Companies

How do we value gold or other precious metals mining company? Their metrics or financial ratios must be different to the average industrial company (http://ozstock.blogspot.com.au/2008/11/fundamental-analysis-ratios-formula.html), simply because of the different nature of the mining business. A mining business may have a fixed term life, may not be profitable now, but may have high potential for profitability and growth. In this sense, it may have something in common with the strategy for biotech valuation (http://ozstock.blogspot.com.au/2007/01/biotech-valuation-indices.html).

The aim of this post is to present a quantitative way of valuing mining stocks, in particular, gold mining companies. This strategy may be modified a little to tailor to other metals mining companies.

Briefly, each of the criteria to assess are:
1. Long mine life.
2. Amount of gold (or other metals) in reserve
3. Time to production, if not producing already.
4. Cash generation ability

Each of this criterion is described in detail, and a number scale for each criterion is explained.

1. Long mine life. Scale 0.0 - 2.0
The company should have a long mine life in order have a good opportunity for growth of the original investment. A mine life of at least 5 years is considered to be good. Hence the Scale should be assigned as follows:
0.0 = 0 year mine life
1.0 = 5 year mine life
2.0 = 10 year or more mine life.
Anything above 1.0 is good.

2. Amount of gold (or other metals) in reserve. Scale 0.0 - 2.0
In order for the gold mining company to become a big producer, we would expect the gold reserves to be at least 1 million ounces. Hence the Scale should be assigned as follows:
0.0 = 0 ounces of gold reserve
1.0 = 1 million ounces of gold reserve
2.0 = 2 million ounces or more of gold reserve
Anything above 1.0 is good.

3. Time to production, if not producing already. Scale 0.0 - 2.0
Another big question is whether the gold miner is close to production or not. Obviously the closer it is to production, the higher the share price. However there is also high risk for explorers who are far away from production. A company closer to production means it is closer to being able to generate cash flow and not relying purely on finance. Therefore this indicator can assist in factoring in the risk. Hence the Scale should be assigned as follows:
0.0 = 1 year or more before production.
1.0 = Production has been started just now.
2.0 = Already producing gold for 1 year or more now.
Anything above 1.0 is good.

4. Cash generation ability. Scale 0.0 - 2.0
Gold miners able to generate cash gives confidence to investors. In addition to generating cash, if the cash flow is positive, it further increases confidence of the company. We consider having 1 year of positive cash flow as favourable. Two years of higher is fantastic. Hence the Scale should be assigned as follows:
0.0 = Has not been cashflow positive yet
1.0 = Cash flow positive for 1 year now.
2.0 = Cash flow positive for 2 years or more  now.
Anything above 1.0 is good.

Master rating. Scale 0.0 - 2.0
To summarize the system, each for criteria, Mine lives, Large gold reserves, Time to Production and Cashflow Positive; have been given a rating from 0.0 to 2.0, where the midpoint is the point of becoming favourable. Once each rating is given, a Master rating can be determined as the average of these ratings.