By Albert Lu, CEO of Sprott US Media
As uncertainty or the perception of future uncertainty in the economy grows, buying gold bullion or the SPDR Gold Trust ETF (NYSEARCA:GLD) presents an increasingly popular financial insurance policy. An alternative is to buy stock in the companies that produce gold or an ETF such as the VanEck Vectors Gold Miners ETF (NYSEARCA:GDX) or the Junior Gold Miners ETF (NYSEARCA:GDXJ).
In a recent roundtable discussion, several heavyweights in the world of gold investing joined me, Albert Lu, to discuss the fine points of valuing gold mining companies. In this roundtable discussion, gold company valuation techniques were unveiled by each: James Rickards, the New York Times bestselling author of Currency Wars; Trey Reik of Sprott Asset Management USA; and Rick Rule, CEO of Sprott US Holdings.
All Mining Companies Are Not Created Equal
Why is due diligence so crucial when considering an investment in a gold mining company?
Rick Rule, CEO of Sprott US Holdings, has a very good answer. For him, the need for information boils down to security.
According to Rule, mining companies can offer attractive returns, but they can also "provide you a way to underperform if you don't pick carefully because there is, if you will, process risk within a mining company."
Rule points out that for 40 years or more, the investment community hasn't incentivized mining companies to excel.
Says Rule, "we've asked the gold mining companies for the last 40 years to be marginal. And sadly, they've complied."
The Danger of Blind Gold Stock Investing
Investing in gold stocks is a high-risk, high-reward activity. Trey Reik, Senior Portfolio Manager at Sprott Asset Management, has spent over a decade analyzing publicly traded gold mining companies.
"Gold stocks, believe it or not, have outperformed the S&P by a factor of 250:1 for 55% of the past 16 years," says Reik.
So, what's the problem?
As Reik stated, "the corrections between those advances were 36%, 75% and 85%..."
While investing in gold miners can create outsized returns for investors, they do not move as one. Our prior Seeking Alpha articles on the importance of researching management teams and the key risks an investor has to research when investing in a gold miner point to the fundamental factors an investor must analyze. These factors help drive the variation of gold stock performance.
Investors should also aim to understand a miner's intrinsic worth.
Net Present Value And Gold Company Valuation
Rule points to net present value as a good way of valuing a gold company:
I like to look at producing gold mining companies the same way I'd look at an oil and gas company, which is to say net present value.
You take the scheduled cash flows, projected cash flows from developed producing reserves, measured, and indicated inferred reserves, and you do an after-tax net present value on them. As you do this, you take out historical and forecasted costs and cost of capital. Try and figure out what the company is worth as it sits and then put in a pricing matrix, a low-side pricing scenario and a high-side pricing scenario to figure out what the business is worth in different situations.
In short, Rule states that the best way to value a producing mine is to model the mining company's income and obligations, then discount that value to present day value. In doing so, the investor focuses on the real reason they're investing in the gold miner - the future cash flows.
Unique Challenges Face The Gold Stocks Investor
Valuing a gold company with a net present value calculation may seem straightforward. After all, the same technique is routinely applied to companies such as Apple (NASDAQ:AAPL) and Under Armour (NYSE:UAA). According to Rule, it's not as straightforward:
It's different…Under Armour presumably will be able to make underwear from effectively the same mills until the end of time. So, EBITDA to enterprise value and price earnings and earnings to enterprise value are important because there is some continuity of the brand. Every day in the gold mining business, if you aren't replacing ounces through acquisition or exploration, your business gets smaller. So, net present value has a terminal calculation in the gold mining business whereas the multiples can be higher in other businesses because of their ongoing concern nature. Yes, you look to optionality in our business. There's not much optionality in underwear is an example. But there's substantial optionality in the gold business. But, the valuations in the gold business, you need to understand that net present value rather than ongoing concern value is much more important.
This gets to the root of the question of recycle ratio. The reason recycle ratio is so important for miners is because miners are depleting their future cash flow opportunities from their current assets when they successfully pull gold out of the ground. As such, when thinking about an NPV (net present value) calculation or any other valuation for gold miners, they can't be treated like other stocks. An investor must focus on the life of the company's assets and how it impacts their valuation model.
Recycle Ratio and Gold Mining Company Value
Because mines are depleting assets, Rule insists one must also study the company's "recycle ratio." How many additional ounces does the mine produce from its cash flow?
How much net present value in ounces are they able to establish either through exploration or acquisition? In other words, is the management team accretive or dilutive in terms of the value that they add from exploration and acquisition?
The challenge lies in understanding the company's ability to grow their cash flow over time. By continuously replacing assets, a quality management team creates ongoing value for shareholders.
Estimating the degree of exploration success, and the associated cash flows, is essential to valuing a mining company. The difference between a good miner investment and a great miner investment is often the difference between a company with undervalued assets now (a good mining investment), versus one that will be able to continue to find good assets that aren't priced in yet (a great mining investment). Good investors identify companies with undervalued assets today. But great investors focus on companies with ongoing value.
Valuing gold mining companies is a crucial prerequisite to investing in their stock. Gold stocks offer rich rewards, but massive downsides await the unwary. Prior to investing, investors should consider a company's stability, net present value, recycle ratio, and management. Incorporating these considerations into one's due diligence helps the investor cut through the murk, avoid pitfalls, and potentially seize vast returns.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: Sprott U.S. Media is an affiliate of Sprott U.S. Holdings Inc., which is under common control with Sprott Asset Management LP. Sprott Asset Management LP offers both SGDM and SGDJ mentioned herein.
Additional disclosure: Past performance is no indication of future returns. The views and opinions expressed herein are those of the author’s as of the date of this commentary, and are subject to change without notice. This information is for information purposes only and is not intended to be an offer or solicitation for the sale of any financial product or service or a recommendation or determination by Sprott Global Resource Investments Ltd. or any affiliated entity that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the objectives of the investor, financial situation, investment horizon, and their particular needs. This information is not intended to provide financial, tax, legal, accounting or other professional advice since such advice always requires consideration of individual circumstances. The products discussed herein are not insured by the FDIC or any other governmental agency, are subject to risks, including a possible loss of the principal amount invested.
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