Canadian Small Caps - Education - Valuing a Mining Stock

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Valuing a Mining Stock

Investing in mining companies is a very risky yet potentially rewarding endeavour. Exploration activities rely on professional judgments and statistically based tests and calculations that often yield few rewarding results. Few properties that are explored are ultimately developed into productive mining operations. Like any other industry, mining companies face traditional risks associated with business but the following factors need to also be carefully considered:

1. Large upfront capital costs followed by years of little or no return.
2. Challenges associated with working in remote locations.
3. Political instability in developing nations or strict environmental in developed countries.
4. Threats of nationalization such as we are currently seeing in Venezuela, Zimbabwe and Bolivia.
5. Labour disputes and safety issues.
6. Operational hazards and risks.
7. Environmental hazards including geological and weather.
8. Fluctuating metal prices and foreign currency exchange rates.
9. Governmental regulation involving permitting and licenses.
10. A mine is what’s termed a wasting asset in that it loses value over time.

Mines just don’t appear overnight. They take years to develop. As such there is a lag in supply when demand picks up. This in turn causes a sharp increase in commodity prices that will ignite a flurry of mining activity as companies scramble to get new mines into production.

Those mines that first get into production will be able to sell their product at a higher price than those that follow as the supply increases. Therefore, it is paramount to be able to select high quality mines that are scheduled to go into production near the peak of a commodity cycle in order to maximize profits.

A mining company goes through several stages:

1. The Eureka Phase: There has been a discovery of an economic metal or mineral but it is unknown how much. It is only known that there is some. From this early stage the chance of becoming a full-fledged mining company is so remote that it isn’t even worth considering.

2. Resource Defininition Phase (Explorer): Additional work is conducted to determine the size and grade of the deposit. Strictly exploration-mining companies are within this stage. Indeed some are concerned only with the discovery of new deposits and determine the quality and quantity of deposits and have no intention of going into construction. By accumulating enough of these prospective properties they can make a handsome profit by merely selling them to mining developers and producers.

3. Pre-Feasibility Stage (Early Developer): At this stage the main question is to determine the economic viability of a project. An independent engineering study would complete a "Pre-Feasibility Study". The method of mining (open-pit or underground) and effective method of mineral processing is determined. A financial analysis based on reasonable assumptions of technical, engineering, operating, and economic factors is made by a qualified person to determine what part of the mineral deposit are "Measured & Indicated Resources" and what portion are "Inferred Resources".

4. Feasibility Stage (Late Developer): Detailed engineering and environmental studies are conducted. A portion of the "Measured & Indicated" mineral resource would be reclassified to "Proven & Probable Reserves". All geological, operating, economic, political and environmental factors are considered in sufficient detail that it can reasonably serve as the basis for a final decision by a financial institution to finance the development of the deposit. An estimate of the "Payback Period" and "Cash Cost" per unit of mineral being mined should also be available.

5. Construction Phase: The mine has proven to be economically viable. Now the required permitting and licensing need to be completed and the process of construction can begin.

6. Production Phase (Producer): The mine officially begins production. Several months may lapse till the mine operates at full capacity. Expansion projects may begin in effort to prolong mine life.

Completing these stages can take years. Also, as the mine moves closer to the production phase the risk of failure diminishes. There are many more properties containing potential mineral wealth than there are properties containing an operational mine. As such, companies closer to production are much more highly valued that those just starting the process.

Whether the company is an explorer, developer or producer should have a great impact on how much the market capitalization should be relative to the size and quality of the deposit.

There are no magic numbers by which to valuate a company. All that can be said is that a Instead a comparative analysis between different companies at a similar stage of development should be completed.

Comparing P/E ratios between producers is useful. For developers consider the debt and payback period of the mining operation and consider the value of the Proven & Probable reserves against market capitalization. Explorers only have the quality and quantity of their deposits available for comparison.

A mining operation with a shorter payback period is obviously preferable to one with a longer one. A larger deposit is superior to a smaller one. But how does a mining operation with a small deposit and short payback compare to one with a large deposit and longer payback period?

Well, that is like comparing apples to oranges and I suppose it depends on whether you prefer the apple to the orange.