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The Gold Stock Strategist analyzes leading junior gold producers and major gold mining companies.

Comments are welcomed!

Saturday, May 31, 2008

Fundamental Analysis, False Precision and Emerging Jr. Gold Producers

World of Wall Street has an excellent post on valuing mining companies written by AceOFKY on May 20, 2008 and titled
Valuing Mining Stocks - In Defense Of Net Asset Value.

This is a must read for investors in emerging junior gold producers because it lays out the pros and cons of three common valuation approaches. The post was also published on SeekingAlpha, Stockhouse, and other widely read venues.

AceOFKY favors the “net asset value” (NAV) method over the “in situ” and “cash flow” approaches—both presented here on the Gold Stock Strategist as the primary method of analysis. In general, I agree with his ideas and want to amplify and extend the following statement from the post:

“There are simply too many unknowns in the mining industry to be able to quantitatively account for future reinvestment with any degree of accuracy”

In my opinion, NAV suffers more from an unknown future than a combination of "in situ" and "cash flow" methods for valuing emerging junior mining producers. But, it can be another important piece in the puzzle of valuing emerging junior gold producers.

This opinion is rooted in the notion of “false precision.” False precision is the idea that an analysis provides a level of accuracy or certainty with regard to the present value of an asset that is dependent on future events. Clearly, it is impossible to know the future and that is the weakness of any fundamental analysis. And the further out in time one projects the value of an asset, the greater the uncertainty.

Some equity analysts account for this greater uncertainty in the NAV method by adjusting the discount rate upward, say to 20 percent. Adjusting the discount rate for political risk, management reputation, potential resources, operational risk, etc. requires a subjective judgment and the discount rate is a quantitative tool for measuring this subjective perception of risk.

In traditional financial analysis, the recommended discount rate is the weighted average cost of capital representing the opportunity cost of alternative investments. Theoretically, treasury bonds with a term of 10 to 30 years are believed to represent a risk free return suitable for use in assessing the attractiveness of alternative investments. Today, a discount rate of about 6 percent would make sense.

So, the upper and lower bounds used for choosing a discount rate for valuing emerging junior gold producers might be 20% and 6%.

In addition, the longer the useful life of the asset, the greater impact the discount rate has on the valuation using NAV.

The inflation rate used is also a key factor that can alter valuation using NAV.

As a way of illustrating how important these assumptions are in driving valuation of an asset, I did a NAV analysis of one of my favorite emerging junior gold producers Metanor Resources. I call this exercise, PICK A NUMBER! ANY NUMBER!

Here are the results.

Disc Factor = 20%

a. Inflation = 3%; $2.25 per share
b. Inflation = 0%; $1.93 per share
c. Deflation = -3%; $1.74 per share
Disc Factor = 12%

a. Inflation = 3%; $3.62 per share
b. Inflation = 0%; $3.00 per share
c. Deflation = -3%; $2.67 per share
Disc Factor = 6%

a. Inflation = 3%; $5.56 per share
b. Inflation = 0%; $4.50 per share
c. Deflation = -3%; $3.93 per share

Using the same assumptions (MI&I, oz. production, cost per oz) used for earlier analyses and new assumptions needed to do the NAV method (15-year mine life, mill value/depreciation, warrants, exploration costs, general and administrative costs, 6%/12%/20% discount rate, etc.) the results for Metanor Resources range from $1.74 to $5.56 per share.

If one assumes only the inflation equal to 3% scenarios (far more likely than the other two inflation assumptions IMHO), the range is from $2.25 to $5.56 per share and compares fairly closely to earlier, less sophisticated analyses.

Interestingly, a sensitivity analysis using the NAV method shows that an inflation assumption of 6% puts the share price range at $2.65 to $6.92--amazingly close to the earlier cash flow and in situ value per share.

My earlier cash flow and in situ valuation methods produced amounts ranging from $2.86 to $6.91 per share. Given all the uncertainty for Metanor Resources over the next 15 years, these valuations are for all practical purposes equivalent in my opinion. I will let the reader judge for themselves.

Of course, I look for companies like Metanor Resources that are just entering the production stage of their development, have no debt, offer great potential resource expansion, exhibit passionate and competent management among other intangibles before risking my hard earned capital.

Needless to say, I prefer cash flow and in situ valuation methods for emerging junior gold producers for the following reasons.

1) It gives me a range of the value of a stock roughly in line with NAV as long as the company doesn't have too complicated a capital structure.
2) I don't have to make assumptions 15 years forward into a very uncertain future. I only have to make assumptions for the next year or two.

3) In situ values the resource based on current market prices.

4) The cash flow method is more dynamic and gives a near term value. I can periodically match operational performance with near term milestones of a company. For example, I would expect Metanor Resources to have their mill processing 800 t/pd by June 2008. If not, I can adjust my projected production estimate and revalue the shares.

5) The NAV method is very time consuming compared to the other two approaches.

Moreover, I am unlikely to hold ALL my shares of Metanor to full value ($6?, $7?, $10?) unless it gets bought out by a major at that level (is that full value?). The upside in exploration will also likely increase the value as the resource unfolds.

Again, I agree with AceOFKY's comparison of valuation methods and was impressed with his logic. In fact, it can be downright fun for those of us steeped in finance and economics to test stock valuations based on multiple assumptions.

That said, cash flow and in situ methods of valuation are sufficient for me given my medium-term investment goals and interest in benefiting from increases in valuation due to near-term (12 to 24 months) increases in value due to emerging production and expansion of the resource. I keep looking for better values in this subsector and so far, none are better than Metanor Resources, Gold-Ore Resources, and Kinbauri Gold IMHO.

In summary, fundamental valuations are just rough guesstimates of the value of a company. The idea that fundamental analysis can tell us exactly what a stock is worth is a misguided belief based on the notion of "false precision." That is why I like to provide a range of share price estimates AND qualify my analysis with the reality that there is risk involved in investing in emerging junior gold producers.

At the end of the day, we take our chances and place our bets. I could be wrong.

Thanks to AceOFKY for stimulating this response and a NAV assessment of Metanor Resources.


Gold Stock Strategist

Full disclosure: I own shares in companies listed above. The information provided in this post is believed to be correct, but not guaranteed. Investing in junior gold miners entails risks. Readers are responsible for their own investment decisions. Do your own due diligence.


Anonymous said...

I think what you have endeavored on is great - most goldbugs need much more education in rational fundamental valuation measures and techniques. Some of the pie in the sky price targets i see on boards i follow are downright delusional. However, you dont show any of the components underpinning the valuations you promote. It would be fantastic to see the mechanics of your calculations - I for one would be greatful and very interested to dig in! something like public google docs spreadsheet is perfect for this...

Cheers and keep up the great work!

AceofKY said...

Hi Scott,
My friend Doug (aka "MontyHigh") sent me to your website. Thank you for your intelligent response to my defense of the NAV valuation method. From your website I see that we share some equities in common, including Gold Resource Corporation (a favorite of mine) and Jaguar (although I sold my JAG position a while back because I thought the share price was getting ahead of itself.)

You are certainly correct that the valuation of an asset becomes more and more uncertain the further you project your assumptions into the future. I certainly didn't intend to suggest that the NAV method yields any level of absolute precision regarding asset value (is there such a thing?); all I'm saying is that it is vastly superior to the in situ and cash flow methods because it takes into account everything that the in situ and cash flow methods do, and more! If one believes that fundamental analysis/valuation is useful at all (many don't, of course) then you have to pick a method, or at least you have to apply some type of a weighting to the method that you feel is most valuable even though you may utilize several methods. There is no question that there is much subjectivity in a NAV valuation. In fact, analysts can butcher a NAV to the point it is virtually worthless. If you want an example, see my recent analysis of Blackmont's NAV valuation of First Majestic:
This was a horrible valuation; any amateur could prepare something better than this professional did. The problem was not with his method, however, it was with the assumptions and data used.

I'm going to look at a couple of your assumptions in your example with Metanor Resources to try to illustrate my point. The article I wrote was really a messageboard/blog post; it was not originally intended to get picked up on Stockhouse, etc., So I didn't do a very good job of providing examples. Let's take a look at Metanor and see if this can shed some light on my argument. All I ask is that you subject your own valuations to the criticism that you leveled at mine. I will work here with the $280/reserve ounce and 10x cash flow assumptions that you used to value Metanor on your website.

1. False Precision - the idea that an analysis provides a level of accuracy or certainty with regard to the present value of an asset that is dependent on future events. I agree, this can definitely be a problem with the NAV method. It is no less a problem with the in situ and cash flow valuations, too. By your in situ method, Moto Goldmines would have a valuation of over $1.1 billion since they have 3.939MM ounces of reserves. Current market cap is $357MM, giving you an upside of over 300%. Of course, you and all other investors would not consider giving Moto a valuation of $280/oz, specifically because of uncertainty of future events. You, in fact, have an excellent article on your website about quantifying political risk. And yet, you are not factoring risk into your valuations. You are doing this "in your head" so to speak. The NAV method gives you a tool to do this quantitatively. Is it subjective? Of course. Is it precise? Of course not. You are already applying the discount in the back of your mind and it has the same subjectivity, so I ask that you don't criticize the NAV method for this. The same thing applies for all assumptions (not just political risk) including future gold price. Do you really think, if gold goes back to $300/oz, that one should still be using a $280/oz valuation? False precision and uncertainty of the future affects all three valuation methods and any other conceivable method. You say that the NAV method suffers "more" from uncertainty over future events than the other methods, but I don't see any argument to this effect. The NAV method specifically discounts future earnings potential because of this uncertainty (along with some other reasons.) The in situ method does not do this at all, and the cash flow method doesn't either. Sure you will say, "I use different in situ valuation scales for different political risk profiles and different cash flow multipliers for higher versus lower cost gold miners." But aren't you just compensating for the deficiencies of the methods? By the time you compensate for all the deficiencies of these two methods, you will end up with something very close to the NAV method.

2. NAV method yields a wide range of Valuations depending on assumptions used. Of course! But this also applies to in situ and cash flow valuations! In fact, when I see these valuations I like to say "Pick a number; Any Number!" Why use $280 per reserve ounce? This would give, for example, Gold Resource Corporation a value of $0 since they don't have any reserves. Using operating companies with reserves, Golden Star trades for $141/reserve ounce. Agnico Eagle trades for $608/reserve ounce. Let's see, this gives us x4 multiplier share price range for Metanor (I don't see that Metanor has any reserves anyway, looking at its website.) Now you will say, $141 and $608 are not the industry averages! That's correct, they are not. The 20% discount rate you used to criticize the NAV method is hardly the industry average either. I've never seen anyone use a 20% discount rate for a gold miner unless you're dealing with a Congo or Venezuela-type situation. The x4 share price range is a larger range than what you found when calculating the NAV for Metanor. Thus, using your own criticism, the in situ method is shown to be a less useful method.
How about cash flow method? Pick a multiplier! Any multiplier! AEM is trading at 44X 2007 operating cash flow. Northgate is trading at about 6.1x 2007 operating cash flow. That's a much worse range. There are very good reasons that AEM trades at a high multiple and Northgate trades at a low multiple. The NAV method gives one the capability to account for those reasons. The cash flow method does not. What does a 10x cash flow multiplier assume? At the bare minimum, it assumes a 10 year operating life (at the same cash flow) unless a company just happens to have a lot of cash on hand. Actually, much more than 10 years is assumed when you figure in the time value of money and capital structures. On a resource company with discrete resource holdings, you can't just assert that it should trade at 10x cash flow without having some type of reasonable substantiation.

3. The cash flow and in situ methods yield valuations roughly in line with NAV as long as capital structures aren't too complicated. You don't give any justification of this, so I don't feel obligated to rebut it. I will only say that my own experience has been quite different; I have found large differences between the NAV and in situ methods when comparing high and low cost miners. And there are large differences between the NAV and cash flow methods when comparing a miner with a large resource base to one with a small resource base.

4. In situ values the resource based on current market prices. I'm not sure why you're presenting this as a strength of the in situ method. If one could assume that commodity prices will remain constant in the future, this would have some value. There is no reason, however, to suspect that this will happen. The NAV method gives us the flexibility of using whatever prices we feel appropriate (i.e. - conservative when finding a buy point; more aggressive when trying to find a sell point.)

5. The cash flow method is more dynamic and gives near term value. My own argument is that this is in fact a weakness of the cash flow method. It puts way too much emphasis on the next year or two and neglects the long-term potential (or lack thereof) of the company.

6. The NAV method is very time consuming. I agree. I don't see this so much as a weakness as just a fact. It takes a lot of work to produce a legitimate NAV estimate. As with most things in life, the value in something is somewhat proportional to the amount of time you put into it. That being said, I do think it is better to keep NAV estimates simple and generate them on many different companies rather than spending days drilling down to the minute details of a company's operations. As I have already stipulated, the NAV method is not a precise valuation methodology (I don't think there is one), but it is superior to the other two proposed. I still usually require about a 40% discount to my NAV estimate before I will purchase a stock because I realize that errors, uncertainty, management incompetence, and subjectivity play a huge role.

In summary, I will just repeat what I have already said. Whatever the strengths are of the in situ and cash flow methods, the NAV method takes them into account. But it also takes into account much more than either of these methods. It is not precise by any standard, and it can certainly be manipulated into something completely unuseful. The value of this method, however, should be apparent to investors. I challenge you to send me a valuation of an asset sealed by a professional engineer or geologist that DOESN'T include a discounted cash flows valuation. I've never seen one. I would never prepare one in my own practise (which is industrial/institutional engineering rather than mining.) The in situ and cash flow methods as such (i.e. - without all of the discount factors and different scales that you keep in the back of your mind) simply neglect too much data to be useful for anything beyond quick back-of-the-envelope calculations.

Thank you for this exchange. I like your website and I think we can share some useful ideas in the future.
Ben Murphy, P.E.
(aka "AceofKY")

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