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.

Valuation - the VectorVest way.

This is an explanation of how the VectorVest system calculates the value of a company.
(For other ways of valuation, see:
Warren Buffet's 1981 Formula for quick valuation   )

The P/E ratio is a common and simple ratio used to estimate the value of shares. It can be used to compare with P/E ratio of different companies in the same sector to see if the share is overprice or underprice. However, the PE ratio is very inaccurate as many stock analyst would know, but still uses from time to time.

The other funny result from P/E ratio is that for companies with No Earnings or making a loss, then the P/E ratio is infinite, hence not published. A better way is to look at the E/P ratio, for companies with no earnings, then the E/P ratio is zero.

Another quantity is the Earnings Yield, calculated like:
        EY = 100 x P/E
but we can use the E/P ratio in there like:
        EY = 100 / (E/P)

The E/P ratio is more intuitive because it is like Dividend / Price which is the Dividend yield, since earnings is like dividend.

Another very important relation that the VectorVest founder discovered is like investors will invest in bonds when stocks are performing poorly and then return to stocks when they perform better. So investments cycle back and forth between bonds and stocks. In the overall picture the yield from both are the same. Bonds yield are determined by interest rates (IY), so
         EY = IY

Now using the previous equations for Earnings Yield (EY), we have
         100 * (E/P) = IY

To find the actual value of the company, instead of price, we use the Value variable (V)
         100 * (E/V) = IY

So the value of a company is:
V = 100 * (E / IY)

This gives a value of a stock such that if we assume we want to get at least the interest rate of fixed bonds, then this formula tells us the value or price to pay. So if the price of the stock is much lower than V, then it is undervalued.


Here are a few useful strategies:
- Look for Green light
- RT 15 SMA > RT 10 SMA
- VST Mighty Mites

Warren Buffet's 1981 Formula for quick valuation

http://ozstock.blogspot.com

Here is a short technical note Warren Buffet's 1981 formula. I came across this from the Money Magazine, June 2009 issue. Hence I do not guarantee that Money Magazine's content is correct or even if this is truly a formula used by Warren Buffet. However, after analysing the formula for myself, I see the merit of it. In fact I will be including this so called Buffet's 1981 formula in my future article which explains my 3-fold Valuation method to decide on buying stocks.

The Buffet's 1981 formula is this:

Value = (ROE / Required Return) x Equity Per Share

where
ROE = Rate of Return of the Company of interest (in %). This can be calculated using Net Profit After Tax divided by Total Equity.

Required Return = Pre-tax required rate (in %) that you would like to get for your investment. For example you may wish to use a long term deposit or long term government bond rate for this.

Equity Per Share = the Equity of a company divided by the total number of shares. These figures can be obtained from the company's annual reports.

This is a quick and simple way to value a company, to see if the company is priced more or less than it is of value to you. Your input comes into the Required Return where you can choose how much you expect from this investment.

Then the formula will produce the value of the company per share. Simply compare this with the current price to see if it is over or under priced. Using this model, a company that can generate a higher return on equity is worth more than one that cannot. Also a company that generates a high ROE and is able to retain all of its earnings and continue to make higher returns, is worth more than a business with the same ROE but forced to pay most of its earnings out as dividends.