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How would you value a natural resource company?

 

Say you want to value a gold mining company “XYZ Gold” with 25 million ounces in resource estimates and 5 million ounces in reserves. How would you value XYZ Gold?

The answer lies in the question itself that you want to value the 30 million ounces in resource/reserves. However, you cannot just multiply this number with the current gold price to get the market value as the 30 million ounces of gold is in the ground and will not be sold tomorrow.

Which absolute valuation method would you use to value the company – DCF or NAV method? The answer is NAV method. DCF cannot be used to value a natural resource company as the basic assumption behind DCF valuation is that the underlying asset or firm would generate indefinitely and there will be a terminal value associated with the same. However, this is not the case with XYZ as an investor/buyer would only pay the monetary equivalent of the current assets (NYSE:NAV) and will not assume the firm to be a “going concern” as the underlying asset (gold in this case) is a non-renewable resource and only replaceable to certain extent.

The valuation of XYZ would grossly depend upon 3 factors:

Stage of Production: We need to look at the stage XYZ is in – Exploration, Mining or Production. Resource/ reserve estimates of XYZ can be measured with higher certainty if XYZ is in production stage than if it is in mining or in exploration stage. And, as the famous Wall Street quote goes “Market doesn’t value uncertainty”, so XYZ would be valued more per ounce if it is in production than if it is in mining stage.

Actual time to production: The closer XYZ is to production, the higher the company is valued per ounce by the investors. Even if two companies are in the same mining stage, the one that is closer to production will be valued more per ounce as market would discount it at a “lower discount rate”. For example, say if firm XYZ is supposed to get into production in 2013 and firm ABC in 2015, one can easily say that cash flow for firm XYZ will start one year earlier so the discount rate used would be lower.

Resource estimates: Value of a firm is not only dependent upon amount of resource and reserve estimates but also type of estimates. There are 3 types of estimates:
a)Inferred resources
b)Measured and Indicated resources:
c)Proven & probable reserves

As a firm moves from closer to production, the amount of proven & probable reserves increases at the expense of indicated and inferred resources. Proven & probable reserves are valued higher per ounce by the market than inferred and indicated. A mining company would have higher proportion of proven & probable estimates than an exploration firm.

Price of resource (GOLD in this case): Although, XYZ is not currently selling gold, its value would be directly proportional to the price of gold as market expects them to sell gold at a higher price in the future and it doesn’t matter even if they sell it 10 years from now! If you place the graph of XYZ and gold side by side, you would find a direct correlation.

I hope you got some basic sense of valuing a gold mining company. I will be discussing the NAV method in my next posts.

I am a Sr. Analyst and cover the mining sector. I would be more than happy to answer any queries that you might have. Please email me your queries at naveen.sachdeva@gmail.com



Disclosure: No position