Finance

Determining the Real Value of Junior Mining Companies

by Brian Tang

nlike industrial companies that have revenues, many mining stocks belong to junior miners that are still in various stages of exploration or development. This means not only that they have no revenues or cash flows, but also that investors need to use different and innovative valuation methods in order to evaluate them. Junior mining involves companies engaged in the earlier and/or smaller scale stages of exploration, development and production. They are inherently more speculative and more risky than other types of investments. However, the old finance rule that more risk equals more potential return holds true. The process of valuation is done for the purpose of determining what an asset is inherently worth, which will likely differ from the market value of the asset. This difference, between inherent and market value, is where opportunities lie. The market value is what the asset is currently selling for. Once the inherent (more commonly known as intrinsic) value of an asset is determined, the investment decision is then a relatively easy one. if: Intrinsic Value is bigger than Market Value, then BUY the stock;

Intrinsic Value is the same as Market Value, then HOLD the stock; Intrinsic Value is less than Market Value, then SELL the stock. Intuitively, you can make the same analogy with any purchase decision. If you believe something is worth more than it is currently selling for, you buy it. If it is selling at a price that is more than the value to you, you do not buy it. In order to value an asset, one needs to build a valuation model, to be used for determining intrinsic value. At Fundamental Research Corp, we use three valuation methods: Discount Cash Flow, Real Options and Comparables Valuation (depending on the stage of the mining company). Inputs The first part of building a model is to determine the inputs. This is where the real analysis takes place. Analyzing the factors that lead to which inputs are used must be done carefully, otherwise you get garbage in/garbage out. Various factors of a junior mining stock are analyzed, from the geological nature of the projects to the political risks involved in the world in which the company is operating.

The following five main inputs are derived for valuing resource companies: 1. Resource Estimate. Resource estimates can be primarily categorized as 43-101 compliant estimates in Canada (calculated by independent consultants) or historic estimates which are not 43-101 compliant. In our valuation models, we use 100% of 43-101 compliant measured and indicated resource estimates. However, for conservatism, we typically discount 43-101 compliant inferred resources and historic resources by 50%. In some cases, we also use resource estimates calculated by our in-house geologists, based on historical drilling and exploration conducted to date. 2. Recovery Rates. For recovery rates, we use information from metallurgical studies conducted to date, as well as recovery rates of comparable deposits. 3.Commodity Price Assumptions. These are determined based on our outlook on the commodities of interest. It is important to note that, for projects that are not currently producing and are not intended to be put into production in the next three years, a long-term outlook on commodity prices is more important than

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current prices. We cannot totally discount the benefits of current commodity prices on projects that are not in production because, if current commodity prices are high, a company targeting that commodity will receive more focus from investors. We also study the impact of commodity prices on share prices, based on historical data. It gives us an idea as to how share prices could react to changes in commodity prices in the future. 4. Operating and Capital Costs. These costs are determined depending on whether the proposed mine is an underground or an open pit mine, the type of metallurgy, geographical location of operations, etc. Typically, we use company specific information and information from comparable deposits to determine our cost estimates. 5.Discount Rates. These are set based on the type of project, stage and geographical location. For example, a project in the DRC, which is in the same stage and targets a similar deposit as a project in the mining friendly province of, Manitoba, Canada, will have a higher discount rate because of the associated political and geographical risks associated with the country. Discount rates are inversely related to fair value. The higher the discount rate, the lower a projects value. Valuation Models Once the above-mentioned five inputs are determined, we input them in our valuation models. 1. Discount Cash Flow Valuation. It is only appropriate for companies in production, very near production, or with enough information that we can reasonably estimate cash flows from production. The theory behind discount cash flow is that the value of every asset is simply the present value of the cash flows this asset produces over its lifetime. It should be noted that DCF valuation models are highly sensitive to commodity price, cost and discount rate assumptions. It is essential for investors to determine the sensitivity of their valuation to each of these inputs. Investors should know what the valuation will be in a worst case scenario to get an idea of the downside potential and, in the best case scenario, to know the upside potential. 2. Real Options Valuation. This is a proprietary valuation model that we use at Fundamental Research Corp based on the Black-Scholes option pricing model. This model is very useful in valuing early stage projects by essentially treating the resource in the ground as an option. Management has the option to pursue a project or abandon it based on new information. Real options valuation has allowed us to put a quantitative value on assets that would otherwise be virtually impossible to value. As a quick analogy, a call option becomes in-themoney when the stock price rises above the strike price. Similarly, our real options model becomes in-the-money when the expected cash flows from a mining project rise above the cost to put the project into production. 3. Relative Valuation. Comparables are selected based on the type of project, stage, geographical location and market capitalization. A companys fair value is determined based on applying the average ratio, most often average enterprise value (EV) to resource, of its peers to the company being valued. We also did a comparables valuation on ROI using 2.6 cents per lbs Cu and came up with a valuation of $0.46. After using one or all of the three methods described above, we look at the fair value determined by each method and use that as a basis for coming up with a final fair value. In the case of ROI, our analysts decided on a fair value of $1.69. At this point you may notice a large discrepancy in the fair value derived from the three methods. While a discussion regarding the reason for this is beyond the scope of this article, some of the reasons that the methods give different fair values are: comparables depend on current market prices, so, if the market is undervalued, all assets will be undervalued; as for DCF and Real Options, one reason for the difference is related to the time assumptions used; options become more valuable as their time to expiry increases. While we are doing our analysis and valuation, we are always looking out for the following red flags: companies with less than three months of cash on hand and that are having problems raising capital; management team with little experience in the industry and in raising capital; higher than industry average management compensation and option pay outs; a board which is not truly independent; non-arms length transactions; companies that do not regularly publish results of their drilling programs; projects located in politically unstable regions or which could potentially have a significant negative impact on the environment. In addition, the following are some common mistakes that we believe investors make in their investment decisions: investors have a tendency to invest in early stage projects (far from production) when commodity prices are high, even though the long-term outlook on commodity prices is not favourable. Although this strategy might lead to short-term gains, it is less likely that such investments will be good in the long-term; companies tend to over amplify the significance of their drilling results. It is very important for investors to look at the true widths and grades of all the recently published results before making an investment decision; a company might have good resources, but if the value of the resource is lower than the total operating and capital costs over the mine life, it might not be a good investment; investing without proper analysis of risks. Although, timing the market is very difficult, if not impossible, investors can keep in mind the following cycle of a
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mining project in determining whether to take a position. During discovery and exploration, there is usually an increase in stock price as investors speculate, based on preliminary drilling or other sampling results, whether or not the company has found anything. As the company defines resources and releases further results, institutional investors usually become interested in the stock. At these stages, the stock tends to increase. Once a decision is made to proceed with feasibility, the stock price may decline as investors worry that a feasibility report may deem the project uneconomic. If a decision is made to go into production, the stock will still remain relatively flat, as investors are uncertain whether a company can secure financing and permits. Once financing and permits are in place, the stock may start to increase again, although at a slower pace, due to uncertainty regarding cost over-runs and other surprises. As the mine starts production, the stock should then increase at a faster rate. The above discussion is a simplification as the stock is also influenced by general market risk and commodity price risk. Analyzing junior mining companies is a serious task and more similar to art than science. However, when equipped with the right tools, analysts should be able to make an informed decision considering the appropriate risks and expected return. * Brian Tang is the President of Fundamental Research Corp

Many mining stocks belong to junior miners that are still in various stages of exploration or development.

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