Disruptive Discoveries Journal

The Fallacy in Mining Valuation

Chris Berry2 Comments

By Chris Berry (@cberry1)

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A great deal of attention has been placed recently on the resurgence in rare earth prices and the concomitant increase in share prices. Given the general bloodbath in the mining sector since 2011, this is extraordinarily welcome news. Nevertheless, it leaves one question unanswered: Is this enough? Specifically, is a double digit increase in underlying commodity prices enough to make specific projects “economic” and justify the start of a new cycle? 

I think the answer in most cases is no, but this then raises a second question. The tailwind of select higher commodity prices (should they last) will undoubtedly help project economics, so how do you accurately value a company with no revenues, no cash flows, no operating history, and management with limited (or no) operational experience?

Add to this other factors including volatility of commodity prices and inputs, geopolitical considerations which are largely out of one’s control and it renders most exploration and junior company valuation difficult to the point of being worthless. Yesterday, Jack Lifton penned an excellent piece listing out his thoughts on what the “best” REE juniors must possess and I agree with his assessment. However, this doesn’t mean valuing one project versus another is an easier exercise.

Many years ago we defined and began using ten “discovery” factors with which to judge an exploration company’s worth. But the subjective nature of these factors demanded more and we complimented this with a discounted cash flow model.

The traditional tool used in financial analysis – the discounted cash flow model (DCF) is useful in the sense that it provides a window into a project’s cash flow and potential. For those unaware, a DCF analysis forecasts a project’s net present value (NPV). It relies on forecasts of cash flows and then discounts them back to today using a discount rate (more on this in a moment) to determine the NPV. In financial circles, any project with a NPV > 0 should move forward though this is somewhat subject to debate.

However, there is a thorny problem with early development stage companies and this goes beyond natural resource plays. This is, of course, the unreliable and biased nature of the estimates of the input data for cash flows and the discount rate. As the saying goes, “garbage in, garbage out.” Assuming a project has a 30 year mine life, estimating 30 years of revenues, expenses, and cash flows, not to mention commodity prices is a fearful and difficult procedure.

The internal rate of return (IRR), on the other hand, is another popular metric used to determine the expected growth rate of a project. It can also be thought of as the discount rate used to make the project’s NPV equal to zero.

While these metrics may provide a fundamental benchmark to use to compare various projects against one another, as I mentioned, they contain many flaws and can offer misleading insights into the superiority of one project versus another.

Specifically, the IRR can’t be used to compare projects with different lives or durations. For example, a project with a mine life of 11 years will return an IRR different from that of a project with a mine life of 20 years. This is because IRR doesn’t consider a project’s cost of capital.

Additionally, the IRR assumes that project cash flows are reinvested at the same rate of return for the entire life of the project. This is arguably the biggest flaw of all. As interest rates and risk appetites can fluctuate sometimes dramatically over time, it is clear that cash flows can be reinvested at varying (sometimes higher or sometimes lower) rates, rendering a single IRR a fickle metric to rely on.

Finally, situations will undoubtedly arise in the life of a project where both positive and negative cash flows are generated. This means that the IRR could have multiple values. There are ways to deal with this by using the Modified IRR, but generally speaking, the DCF tool used to generate a NPV is a more widely used metric in project and company evaluation.

There are some challenges with DCF analysis in that inputs must be constantly tweaked (input costs fluctuate, growth rates can change), but it is arguably a better metric to rely upon relative to IRR given this necessity to manage the inputs.

The real challenge in evaluating junior mining companies, be they REE, graphite, lithium, or gold, is the amount of subjectivity, or guessing, one must undertake to try and arrive at a conclusion. Nowhere is this more prevalent than in the Energy Metals space where the oligopolistic and specialized market structures provide a poor benchmark for aspiring producers vis-à-vis discount rates, production methods, etc.

As an example, using FMC Corp. (FMC:NYSE) or SQM (SQM:NYSE) (lithium producers from brine in South America) as a proxy for an aspiring hard rock play doesn’t make sense (though it may for an aspiring brine play). Production methods are entirely different, FMC and SQM are in a different part of the world with different regulatory structures, cost structures are different, pricing is sure to be different (FMC and SQM will surely receive a higher price for their products than a new entrant into the space) and as producers, FMC and SQM are less risky than an exploration or development play.

This concept of risk is typically measured by beta which is a measure of the volatility of a company’s returns versus the returns of the overall market. Discussion of this metric is likely enough for an entire other piece.

Choosing an appropriate and realistic discount rate is a core issue and source of much disagreement. The discount rate is the interest rate used in a DCF which discounts project cash flows to today’s dollars. It encompasses numerous factors, many of which have been alluded to earlier in this piece. Between 2002 and today (with the exception of 2007-2008) much of the research I read on company projects uses a discount rate of 8%. This was (and still is) ridiculous and much lower than it should be be. Of course, a higher discount rate would harm the economics of projects, rendering many uneconomic, but given that the small cap mining space is a high risk speculative environment (to put it mildly) higher discount rates are necessary. Applying the same discount rate to different projects runs the risk of either understating or overstating the challenges a company may face.

Here is a brief theoretical example:

Company A has a NI 43-101 large measured and indicated resource of graphite in Canada, 40% of which is suitable for the battery industry and high margin applications. The company has a bankable feasibility study in hand, sound management, no off take agreement, and average cap ex and op ex. The IRR listed in the BFS is 35%.

Company B has a small JORC indicated and inferred resource of graphite in Africa, and though more drilling needs to be completed, about 60% is suitable for the battery industry and high margin applications. The company has a preliminary economic assessment in hand with a 30% margin of error, and very low potential cap ex and op ex. No IRR yet exists.

What discount rate should be applied in DCF analysis to the above projects?

8%? Despite the fact that Company A is “further ahead”, both companies deserve a higher discount rate as several risks (specifically financing) have not been addressed. Yet most bankers and professionals would use the 8 to 10% rate as a “benchmark” despite the fact that these projects are dramatically different. They face uncertain demand profiles, currency and other macroeconomic headwinds, different operational challenges, the need for off take agreements, and the list goes on. Higher discount rates make the investible universe of companies smaller but offer a clearer picture of a company’s potential.

One wonders if the subjectivity inherent in the DCF exercise is worth the risk. To get around this, we have used Fuzzy Logic, a system which allows for “imprecision” rather than traditional true or false variables. This system works best when crowd sourced and leverages the wisdom of crowds to wring out the subjectivity in a valuation exercise. Of course, the larger the crowd, the better and this is sometimes an issue in dealing with small cap mining companies – they are typically underfollowed.

Ultimately the question of risk measurement and management reigns supreme and all of the analysis above doesn’t deny the fact that demand for Energy Metals continues to grow well above global GDP growth rates. I still believe we’re at a cyclical and structural bottom in the metals markets (I have stated this many times before) and now is the time for extensive due diligence on various projects. The real question that I’m addressing is how to rationally and equally evaluate the various projects in this sector when so many unwieldy variables exist. I’m not writing this piece to say that one valuation method is superior. If there were a perfect model, we’d all be using it and markets would truly be efficient. I’m writing this to say that while higher prices are a welcome tailwind, they can’t be relied upon to produce an objective outcome and project value. The speculative nature of the small cap space will continue to be an issue to be dealt with but this shouldn’t diminish its importance to global supply chains.   











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