Valuation methods for mining projects: Art or Science?

The process of valuation is performed for determining what an asset is inherently worth, which will likely differ from the market value of the asset. The difference, between inherent and market value, is the opportunity for value creation. By property valuating mining assets, investors will have the key information for effective decisions.  However, valuation mining assets is a complex matter because of the characteristics of the mining industry.

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Figure 01: Inspecting diamonds

According to DBRS’s ratings methodology for mining companies (2011), the mining industry has the following characteristics that differ from other industries:

  • On average, mining industry operating margins are higher than average due to high capital intensity, the need for large upfront investments and higher-than-average investment risk, leading to a high cost of capital;
  • Earnings volatility is high and periods of low or high profitability can persist for many years as production surpluses and/or shortages are brought into balance;
  • Mining largely produces commodities; therefore, producers are price takers;
  • The industry has significant barriers to entry, including resource discovery, long lead times for development, high capital costs, and often remote developments bereft of infrastructure, high regulation, political and social instability issues and, increasingly, the need to maintain a solid public reputation as an industrial operator with a “social license” to mine;
  • Regional markets may develop in response to the high proportion of transportation costs in the cost structure of certain bulk minerals;

Also, the planet has finite quantity of natural resources; therefore metals and mining is a finite business. The longevity of a commodity company depends consequently on astute acquisitions, successful exploration, and/or a range of non-mining or downstream businesses. When valuing commodity companies, scarcity of resources plays a significant role in forecasting future commodity prices as well as constraining the assumption of perpetual growth (Adapted from Baurens, ‎2010).

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Figure 2: Inspecting core samples

There are three different main categories of mineral properties (Adapted from Roscoe, 2007):

Exploration Properties are those which an economically viable mineral deposit has not been demonstrated. The real value of an exploration property lies in its potential for the existence and discovery of economically viable mineral deposit. Only a very small number of exploration properties will ultimately become mining properties, but until exploration potential is reasonably well tested, they have very little value.

Development properties are those where economically viable deposit has been demonstrated to exist by a Feasibility Study or Pre-feasibility Study, but is not yet financed or under construction. Such properties are at a sufficiently advanced stage or are former producing mines. There is enough reliable information available to value the property by discounted cash flow methods, with a reasonable degree of confidence. In general, such information includes reasonably assured mineable reserves, workable mining plan and production rate, metallurgical test results and process recoveries, capital and operating cost estimates, environmental and reclamation cost estimates, and commodity price projections.

Production Properties are mineral assets that are in production.

The value of any mining asset is directly derived from the value of its mineral resources. Various methods are available to estimate a company’s value but many are not useful or applicable. The approaches used to value a business depend on available information and how marketable its assets are, whether it generates cash flow, and how unique it is in terms of its operations. There can be significant differences in outcomes, depending on which approach is used. Moreover, even traditional methods such as Discounted Cash Flow, Relative Multiples or Real Options cannot be applied without some adjustments and demarcations (Adapted from Roscoe, 2007).

Traditionally, there are three different approaches to valuation, which are applied to the three main categories of mineral properties (Adapted from Baurens, ‎2010):

  • Income or Cash Flow: Relies on the “value-in-use” principle and requires determination of the present value of future cash flows over the useful life of the Mineral Property. Examples: Discounted Cash Flow, Real Options, Monte Carlo Analysis and Probabilistic Methods;
  • Market: Relies on the principle of substitution. The Mineral Property being valued is compared with the transaction value of similar Mineral Properties, transacted on an open market. Examples: Comparable Transactions, Option Agreement Terms, Gross “in Situ” Metal Value, Net Metal Value per unit of metal, Value per Unit Area and Market capitalization;
  • Cost: Relies on historical and/or future amounts spent on the Mineral Asset. Examples: Appraised Value, Multiples and Geoscience Factor;

Typically, when enough data is available, the return on investment is calculated using discounted cash flow, as part of the financial analysis of the project. This methodology can be enhanced by applying discount rates adjustments to reflect risk factors for the associated project. As a project moves past the feasibility stage and into detailed design, construction, commissioning and operation, uncertainty associated with the risk components are reduced and other methods such as multiples and/or real options can complement effectively the evaluation (Adapted from Smith, 2000).

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Figure 3: Emerald in dolomite

Remember that any valuation is as good as the data and the premises considered. Therefore, proper due diligence is key for avoiding the “garbage in/garbage out” effect.

Kind regards,

Ronaldo

Follow me on twitter @rcrdossantos

References:

Baurens, S., “Valuation of Metals and Mining Companies”, University of Zürich, Swiss Banking Institute and Prof. Dr. T. Hens, (November, 2010).

Domingo, E. V. and Lopez-Dee, E. E., “Valuation Methods of Mineral Resources”, 11th Meeting of the London Group on Environmental Accounting, Johannesburg, 26-30 March 2007, (March, 2007).

Davis, G. A., “Economic Methods of Valuing Mineral Assets”, Division of Economics and Business, Colorado School of Mines, Golden, CO. June, 2002).

DBRS, ”Methodology Rating Companies in the Mining Industry”, DBRS publications © (June, 2011).

Smith, L. D., ”Discounted Cash Flow Analysis, Methodology & Discount Rates”, CIM-PDAC Mining Millennium 2000, (March , 2000).

Roscoe, W. E., “Valuation of Mineral Exploration Properties Using the Cost Approach”, Canadian Institute of Mining, Metallurgy and Petroleum, © 2007, (July, 2007), Last accessed on 06/14/2016 at http://web.cim.org/mes/pdf/VALDAYBill_Roscoe.pdf

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