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Mining and exploration



How to value mines

Peter Temple
31.01.06


 

It is a part of investment that is definitely more art than science. In a mining boom, all sorts of claims are made about the reserves contained in mining prospects, and on occasion many of these have been found wanting. Mark Twain called a gold mine ‘a hole in the ground with a liar on top.’
 
But assuming that you have a reasonably copper-bottomed idea of the reserves a mining project contains, and some estimate of rates of output and costs of extraction and processing, there are some time-honoured techniques for arriving at a value for a mining project or mining company.
 
DCF Analysis and NPV Value
 
The best established of these is discounted cash flow (DCF) analysis. This works by estimating the likely cash flows in each successive year from the project, up to about 10 years out, and discounts each one by a factor that reflects the time value of money plus a further adjustment to reflect the inherent risk of the project. Cash flows further and further out in the future are ascribed a bigger and bigger discount factor.
 
In simple terms the discounted cash flows are then totted up, and the total (including some allowance made for potential cash flows more than 10 years out) is divided by the number of shares in issue to arrive at a per share value. This so-called ‘net present value’ (NPV) figure is then compared with the current share price.
 
How discounting works
 
It is obvious that the crucial assumption here is the discount factor applied to the stream of cash flow from the project. But why discount at all? The simplest reason is that, if you invested cash for a year from today, you could earn something over 4% on it. Therefore cash received in a year’s time is actually worth less to you than cash now. The present value of cash in a year’s time, discounted at 4%, is actually £96.15 (100 x 100/104). In other words, £96.15 invested at 4%, will equate to exactly £100 in one year’s time. Cash received two years out would be discounted by the amount of two year’s compound interest, that received three years out by three year’s, and so on.
 
The convention is to discount by the risk-free rate appropriate to the time horizon involved. For a model looking at ten years of cash flows, the natural base discount rate to use would therefore probably be the yield on a five-year government bond, five years being the mid-point of the payment stream.
 
Risks
 
However, this is where the concept of risk and reward, which underlies all investment activity, kicks in. The fact is that most mining projects involve a considerable amount of risk. Ore grades may not be as expected, extraction and processing costs may be higher than expected, political instability might intervene, the selling price of the refined metal may be volatile, and sales receipts could be lower than expected. All of which argues strongly for discounting the future flows of cash by a discount rate appreciably higher than the risk-free one.
 
Asia Energy
 
Let’s have a look at how this works in practice. Take Asia Energy. This company is involved in developing a large coal-mining project in Bangladesh, which will provide high-grade coal for the burgeoning Indian steel industry. The mine is currently at the pre-start up phase but cash flow is expected to turn strongly positive from 2009 onwards.
 
JP Morgan Cazenove, the company’s broker, in a report last May, worked out net present value (NPV) for the project on the basis of a range of coal prices and different discount rates, ranging from 10% to 14%. Assuming a coal price of $44/tonne and a discount rate of 12%, the net present value of the project came out at 1130p a share.
 
Since then, however, the company has placed additional shares and the numbers have been revised accordingly. A report in November 2005 from Evolution Securities put the present value of the project on a 12% discount rate at 822p a share. Asia Energy’s current share price is 434p.
 
International Ferro Metals
 
Another interesting case is the example of International Ferro Metals. The company is involved in chromite mining and manufacturing in South Africa. Existing mine infrastructure is being expanded and an integrated ferrochrome production facility built on the site to enable production of commercial qualities of the metal to be produced for export to world market.
 
Ferrochrome is a key ingredient in the production of stainless steel. Extraction and production costs at the site are among the lowest in South Africa due to the integrated nature of production and modern design. The output is high quality, and South Africa accounts for 77% of this type of ferrochrome.
 
Different calculations
 
Cash flow projections contained in the company’s listing document suggest a conservatively calculated NPV for the project would be R3.13bn based on a discount rate of 12%. This equates to around £300m at current exchange rates, or about 72p a share. The company is unlikely to be consistently cash flow positive until 2011 and beyond. A report from Numis at the end of November, however, reckoned that, with different assumptions, a similar net present value calculation using a discount rate of 12% would produce a per share NPV figure of 139p per share. The current share price is around 30p.
 
Ferrochrome and stainless steel prices were particularly buoyant in the second half of last year, and this may or may not continue. But the difference between the two calculations does illustrate how sensitive cash flow models are to changes in the assumptions underlying them.
 
Yield and enterprise value
 
DCF calculations are not the only way of valuing mining companies. Few people now value mining projects on an earnings basis. But some smaller listed South African gold mines used to pay out most of their profits in dividends, and were usually valued on a yield basis, and prices moved in response to defined trading ranges based on yields.
 
Now, however, a more popular ready reckoner is to value mining companies on the basis of their enterprise value (market capitalisation plus net debt) compared to the underlying value of reserves in the ground at the current market price of the metal. It is a number that is fairly easy to find, but it says nothing about the cost structure and profitability of the mine, or the political risk attached to it, both factors which can at least be incorporated, however approximately, in discounted cash flow models.