The big picture is this:
- Mining projects in the earliest stages of development are the most difficult to value. As more and more drillholes are sunk into a property, we know more and more about the size and the nature of the deposit.
- When senior miners invest in a project, they will have (A) access to engineering data and (B) a team of specialized engineers. Institutional and retail investors virtually never do this level of due diligence.
- In general, mining assets are very difficult to value precisely or accurately. Mining professionals will often come to different conclusions about the same property.
The commonly-accepted method for valuing a mining asset is to use a discounted cash flow (DCF) model. You guestimate how much the mine will make, when it will make that money, and how much everything costs. The DCF model will yield a Net Present Value (NPV) figure.
The main problem with DCF models is that they suffer from “garbage in garbage out”. There can be a lot of uncertainty in the underlying assumptions in a DCF model.
Uncertainties in the mineral deposit:
- The size of the deposit. More drilling will help figure out the size of a deposit. However, there comes a point where you hold off on drilling since it is not economic to perform more exploration drilling. For example, drilling long holes is very expensive. An underground mine project might hold off on such drilling until an exploration shaft is sunk. The exploration shaft will reduce the cost of drilling since you can drill deep targets with short holes.
- The geometry of the deposit. Deposits with complex geometries make resource estimation more uncertain. Infill drilling reduces this uncertainty, but there comes a point where you have to live with some uncertainty as more infill drilling is not economic. Gold deposits tend to have complex geometries, whereas potash deposits tend to have very simple geometries.
- The distribution of grades. Erratic distributions of the mineral adds uncertainty to the overall estimate. Gold and diamond deposits tend to have erratic distributions.
Social and political factors:
- Is the country politically stable? For example, the Democratic Republic of Congo currently has armed fighting.
- Will the country steal foreign assets? Again, the DRC is an example of a country that expropriates foreign assets.
- NIMBYism and environmental NGOs can be barriers to a project going forward.
- First Nations issues.
- Cutting-edge mineral processing techniques that haven’t been used on a commercial scale before are subject to technology risks. The acid spills in Vale’s Goro project is an example of metallurgical risk.
- Impurities in the ore and the nature of it can affect the economics of a project.
- It can be easy to underestimate the actual costs of building the supporting infrastructure of a mine.
- The cost of mining can fluctuate depending on energy costs, the supply and demand for mining equipment, the cost of labour, etc.
- Sometimes honest mining professionals will be overly optimistic. Human beings tend to be overconfident in their skills. A geologist may be overconfident in his/her ability to find an economic deposit. A metallurgical engineer may be overconfident in his/her ability to bring down mineral processing costs.
- Incentives drive behaviour. Unfortunately, this leads to a lot of perverse and dishonest behaviour in the mining industry. Almost all NI 43-101 technical reports inflate the true economics of a project. There are many estimates that aren’t anywhere close to reality.
So I think now you see why senior miners will bring in their engineering teams to vet a deposit. This stuff is really hard.
Valuation method A: use market values
Sometimes a senior miner (or other mining company) will take a strategic stake in a junior. You can read their agreement carefully and infer the market value of the mining asset. In the future, other buyers will likely place a similar valuation on the asset. It is rare for buyers to significantly over/underpay for an asset. However, it does sometimes happen. Teck paid far less for their stake (10%) in Voisey’s Bay than Inco. Teck’s investment in Voisey’s Bay lent credibility to the junior who owned it and Teck did not get involved in a bidding war. Robert Friedland is a guy who understands salesmanship and he actively tried to pit the buyers against each other.
If you use an implied market value for an asset, you should pay attention to:
- Fluctuations in commodity prices.
- Fluctuations in mining costs.
- Whether or not the buyer overpaid. Sometimes buyers will do this. A senior may be inclined to overpay if their stock is overpriced and can be used as currency. Or, the senior desperately needs a new story to keep its pyramid scheme going.
- The level of due diligence performed by the buyer. Technical reports on the property may reference any due diligence performed by partners. It is standard practice for a senior miner to take splits of the drillcore and to run their own assays on them. They will also re-assay the pulps and perform other QC checks.
Valuation method B: perform your own back-of-the-envelope calculation
This is not a very reliable method of valuing a mining asset. But here’s how you do it.
First of all, you need to understand mine engineering (see my review of mine engineering books). Then, you try to find operating mines that are similar to the one you are trying to value. The method of mining and proposed mineral processing techniques need to be very similar. Then, you simply assume project A will have similar costs to mine B. You may apply various adjustment factors for differences between the operations.
Mining professionals do these rough calculations all the time and come to wildly varying conclusions. This may not be a very reliable method.
Valuation method C: believe NI 43-101 technical reports
Not a good idea in my opinion. Almost all of these are inflated.
Valuation method D: does the company and its joint venture partners believe in the project?
If the (part-time) management team at a junior realizes that the project doesn’t have viable economics, they will likely look for a new story to sell to investors/gamblers. If a company suddenly isn’t putting all of its money into its flagship project, then this may be a sign that the project isn’t economic. Normally the next stage is to spend more money than you spent last year on in-fill drilling, metallurgical tests, engineering, permitting, etc. If they aren’t spending a lot of money on the project, it could be because management does not believe in the project.
Another sign to look for is the behaviour of any joint venture partners. If the JV partners aren’t committing capital to the JV and letting their interest in the project be diluted, it is likely because they do not believe that the project is economic.
Is valuing mining assets too hard?
Possibly. I’m not very comfortable with mining companies for this reason.