Analysing... Miners

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Mining share analysis is a mixture of qualitative and quantitative, and the factual and hypothetical. Added to which is the inherent cyclicality of the mining industry and the volatility of the prices of the metals and minerals the industry extracts.

Analysis techniques in this sector vary to some degree on the size and maturity of the company in question. Analysts use different methods to rate large producing companies to those applied to small exploration plays, which may have reserves but have yet to produce an ounce of metal.

Analysing larger mining companies

In days gone by, large mining companies used to have a web of cross-holdings in other, smaller, listed mines and could be valued quite easily by totting up the stockmarket value of their various percentage holdings. Now, most companies own their production directly or through unlisted joint ventures, so the scope for a stockmarket-based 'sum of the parts' analysis is minimal.

Nor does conventional scrutiny of price/earnings ratios (P/Es) and yields really work as a means of valuing mining shares. This is because of the industry's cyclical nature and the volatility in earnings introduced by fluctuating metal prices.

As in all cyclical industries, P/Es can be low just when investors shouldn't buy the shares - at the top of the cycle. For this reason analysts lean heavily on discounted cash flow analysis. But even this is not without its problems.

Discounted Cash Flow (DCF) analysis relies on forecasting revenue and cash flow for at least ten years ahead. This involves assumptions about metal prices and for non-US companies, since virtually all metals are priced in US dollars, currency rates to the dollar. Costs of extraction must also be modelled.

Political risk needs assessing too, since many mines are in politically unstable countries and the extraction of precious natural resources by foreign companies is invariably a hot political issue. An adverse assessment of political risk can be incorporated in the discount rate used in the DCF calculation.

The historic volatility of the shares can, on occasion, provide a rough guide about what investors think about political risk and/or the like course of metals prices.

Similarly, once the undiscounted cash flow stream has been estimated, working backwards to calculate what discount rate equates discounted cash flow to the current share price. This provides some indication as to whether the market's view of the situation, and perhaps an investor's own assumptions about the likely cash flow to be generated by the company, is out of kilter.

Analysing smaller mining companies

Analysts use similar tools to value smaller exploration plays, with one important difference.

In this instance, the precise delineation of the scale of the reserves available to extract may be hazy, and the evolution of the project to mine them may still be some way into the future.

Mining companies use a specialised standard vocabulary to distinguish between reserves that have been proved to exist and whose size can be estimated with reasonable precision, and those other resources which might be there but whose size and scale are sketchy.

Many mining companies, even large producers, are sometimes valued on the basis of 'metal in the ground'. If analysts use this technique it is common to apply a sizeable discount factor to the sketchier 'resources' (whether measured, inferred, or indicated) of a company and to focus mainly on 'proven and probable' reserves as the main indicator for valuation.

Even here it is debateable whether the full value of the metal in the ground should be used, if for reserves that are highly likely to be extracted. One leading mining analyst, for example, simply valued companies on the basis of 10% of the metal in the ground, irrespective of its likelihood of extraction.

The attraction of this approach, whatever assumptions are made, is that it is flexible enough to apply to a range of companies mining different minerals. Its drawback is that it takes no account of political risk or the costs of extraction, both of which can vary considerably from project to project.

As Michael Coulson, author of 'An Insider's Guide to the Mining Sector' (Harriman House, 2004), observes: "many mining companies are formed, but only a handful for any length of time to earn profits and pay dividends, and only once in a blue moon does one of these become a giant".