"Valuating Gold Producing Companies
To determine if an investment in a gold producing company is a good alternative for a gold investment, I first must determine how gold mines are valuated. The most used methods are the Net Asset Value (NAV) and Cash Cost methods. Valuating mining companies is different from valuating most other companies. After a certain period, a gold mine is depleted. As a consequence, traditional valuation ratios such as P/E can be misleading. If a mining company has a P/E of 10 and dividend payout ratio of 50%, an investor can earn his investment back in 20 years. If a mine is depleted in 8 years, the payout ratio can be considerably reduced.
Cash Cost valuation
To valuate a mining company, the simplest method is to examine the Cash Cost of a company, which is the cost of extracting one ounce of gold from a mine. Cash Cost include Cost of Goods Sold (COGS), mining royalties and administration cost. Cash cost excludes non-cash costs, such as DD&A (Depreciation, Depletion & Amortization) and overhead costs not made at a mining site, such as general & admin, interest payments and corporate taxes. COGS makes up the bulk of Cash Cost and consists mainly of labor, energy and equipment costs. Furthermore, Cash Cost does not include Capital Expenditure (Capex) and impairment charges. Cash Cost is calculated on a by-product basis, a method that subtracts the sales value of other metals, such as copper and silver from the gold cash cost.
Since gold is sold on the global market for the same price, the company with the lowest cash cost is expected to have the highest profit margin. However, many costs are excluded in the Cash Cost and therefore do not represent the company’s profitability. Cash Cost can be used as a comparison to other gold mining companies.. An excellent infograph on Cash Cost can be found at VisualCapitalist.
All in sustaining Cost valuation
The World Gold Council developed a new reporting method, All In Sustaining Cost. The biggest difference with Cash Cost is that it includes sustaining capex, or the money spend to keep mines running at the same production as in the past. It also include some non-cash cost, such as development and exploration cost and also overhead costs, such as General & Admin and exploration expenses. It does not include impairment charges, interest payments, corporate taxes and project capex, which is money spend on developing or acquiring new mines.
Most mining companies historically reported their Cash Cost and by 2012 also reported All In Sustaining Cost. This is a major improvement, since they reflect the synergies between a company’s separate gold mines and the headquarters. All in Sustaining Cost are still reported on a by-product base, therefore companies that produce by product metals report lower cost.
Rising cash cost puts a downside protection on the gold price. When the cash cost is higher than the gold price, mining companies will attempt to halt production at those mines until the gold price increases. In the first half of 2013, the gold price hit a low of $1190, a price level below the All in Sustaining Cost of many gold miners. The gold price recovered to above $1300 a few weeks later, a level just above profitability.
Net Asset Value
However, the gold reserve a company holds is its most valuable asset and is unaccounted for in any cost reporting. A more inclusive method to valuate a mining company is to estimate its Net Asset Value (NAV), which is the Net Present Value (NPV) of its future cash flows and other balance sheet items. The future Free Cash flow for each mine is based on an estimated future gold price, future costs, annual production rate and gold reserve. To calculate the NPV of these cash flows, a discount rate must include various risks including financial risk (bankruptcy), political risk (nationalization and strikes) and geological risk (earthquakes or floods).
No investor wants to pay more for a mining company than the worth of its NAV. But it is common for the Price / NAV to hover around 1.5 to 2.5. This ratio is based on the leverage effect of gold mines. When the gold price increases by 20% from $1500 to $1800 and a company’s cash cost remains at $600, its profit margin increases by 33% from $900 to $1200. Therefore, this leverage must be included in the valuation. The following are steps to make a realistic valuation when buying a mining company:
If the market value of a company is higher than its NAV, the investment is a speculation that the gold price will increase.
Apply the Black Sholes option pricing model to calculate an “option value” for the gold reserve.
Add the option value to the NAV.
Nationalization
Argentina, Venezuela and Bolivia have recently nationalized companies involved in mining and energy. In 2012, politicians in South Africa have threatened nationalization of gold mines, where Zimbabwe actually did nationalize mines. It can be difficult to quantify the threat of gold mine nationalization. When the gold price rises, so does the envy of some politicians. As the gold price increases, the chance that a government will nationalize the mine directly, or indirectly through high royalties or a majority stake, will increase too.
Gold Price Speculation
Investing in gold mine stock is in effect the act of speculating on a rise in the gold price. During the period of June 2007 to Aug 2013, an investment in gold had a superior return and lower volatility than an investment in mining stock. Therefore, it can be assumed that investing in assets designed to speculate on the gold price, namely Gold Futures, Gold ETFs or options on those, is a better investment than stock. As described above, a proper valuation of a gold mining company includes a number of guesstimates, estimates without proper information. This makes stock picking of gold miners notoriously difficult."
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