An Alternative Valuation Approach to Precious Metal Royalties

Arbitrage & Precious Metal Royalty Companies

Most royalty or streaming valuations rely on multiples. The gross income multiple is the most widely used multiple in royalty valuation. Sometimes analysts will go further and calculate the present value of a stream. These methods of valuation are great tools, but they cannot entirely grasp the streaming business model.

A gold stream involves an upfront cash payment in exchange for the right to purchase a percentage of a mine’s annual gold production at a fixed price per ounce. Notice a stream has the same characteristics as a call option. The fixed price per ounce is the strike price, and the upfront payment is the option premium. A 10-year stream is just 10 European call options, with one option expiring each year for 10 years. A stream is actually just a set of European call options.

If a stream is just a call option, then it follows that option pricing can be used to value a single stream or an entire streaming company. Sophisticated option pricing methods are controversial, but there are non-arbitrage option pricing constraints that are indisputable and universally accepted. These constraints are valid because arbitrage opportunities arise if a constraint is violated. Here is the fundamental constraint concerning streams: The minimum price for a European call option (stream) is the spot price, minus the present value of the strike price.

For example, suppose spot gold is $1,500 and the interest rate is 5%. A one-year, $400 strike call option on gold has a minimum price of $1,120. The present value of the $400 strike is $380. The spot gold price ($1,500) minus the present value of the strike ($380) equals the lower bound ($1,120). This same process can be used to value a stream.

Example

Consider Sandstorm Gold’s (SNDXF.PK) Aurizona project, which allows Sandstorm to purchase gold at $400 an ounce. The table shows the results of using the option pricing rule above to evaluate Aurizona:

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The lower bound for Aurizona is $394 million. Using the lower bound rule to price the Aurizona stream reveals that this project alone is worth more than Sandstorm’s current market cap of $310 million. Investors are getting Sandstorm’s other projects for free at current prices. Here are the lower bounds for all of Sandstorm’s projects:

The total value of Sandstorm’s operating assets is more than $985 million. Adjusting for cash and debt, Sandstorm’s Net Asset Value is about $1 billion. According to the non-arbitrage constraint, Sandstorm Gold trades as if spot gold were $628.96. Sandstorm’s NAV per share of $2.81 gives Sandstorm Gold a 233% margin of safety.

Here’s how the non-arbitrage lower bound works for call options. Consider the one-year, $400 strike call option above. An arbitrage opportunity is available if the option sells for less than $1,120. For example, if the option traded for $1,100, an arbitrageur would first short gold for a cash inflow of $1,500. Second, he would buy the call for a cash outflow of $1,100. Third, the arbitrageur would invest $380 at 5% interest for one year. In all, there is a $1,500 cash inflow and a $1,480 cash outflow. There is a net positive cash flow of $20. After one year, the $380 is worth $400. This $400 is used by the arbitrageur to exercise the call. The arbitrageur then covers his short position with the new ounce of gold from exercising the call. After all this, the arbitrageur is left with a riskless $20 net positive cash flow.

Present values and royalty multiples are not the only way to value streaming companies. The non-arbitrage pricing method is another tool in the investor’s toolbox. Although it can only be applied in the manner presented above to a small handful of companies, it can't hurt to use.

Disclosure: I am long SNDXF.PK.