Mining Company Fundamentals 101
Troy Schwensen CPAIn my last article (See www.gold-eagle.com/editorials_05/schwensen012606.html ) I made reference to a handful of factors that I believed were important when considering purchasing shares in a mining junior. Today I intend to go through each attribute in more detail. By incorporating these factors into a purchase decision it is my belief you stand a better chance of successfully negotiating the minefield that is the junior mining sector.
Before we proceed:
Warning! Warning! Warning! The following contains material that could put an insomniac to sleep and no I am not joking!! However, I wouldn't put you the reader through this if I didn't think the content was beneficial. At the risk of losing you before the end I will take the opportunity now to tell you about a free monthly newsletter I will be running which will include real life examples of how the following content is applied (Much more interesting and hopefully lucrative). Just drop me an email at the address below if you are interested. Otherwise here we go:
1. Insider Ownership of Shares (Ideally 5% + of the Outstanding number of Shares)
The single best way of aligning management's interests with shareholders is for management to put their money where their mouths are and buy a reasonable stake in the company (Ideally 5% + of outstanding shares). It is my experience that management who own a reasonable stake in the company, are generally more responsible in managing share capital. They are less likely to dilute shareholder wealth with excessively undervalued capital raisings coupled with ridiculously generous freely attached warrants and options.
Australian: A company's annual report which you can find on the company website or going through company announcements which can be found at the following site www.asx.com.au/asx/statistics/announcementSearch.do. Changes in Director Interests are also reported in company announcements which you can also find on the above website.
Canadian: Canadians can find this information at the following website:
2. Options/Warrants issued (The smaller the % of Total Warrants/Options as a ratio of overall Shares Outstanding the better)
Excessive warrants and options are a stock price's worst enemy. Back in early 2004 I bought into a Canadian mining junior at $1.50 without studying the outstanding warrants, only to find the share price free fall without any idea as to why. I later found out the company had issued a large quantity of warrants exercisable at $0.60. The share price was trading at close to $2.00 when the new shares became free trading. The opportunity to take profits was too good to resist and everyone hit the exit doors at once. Companies that have quality assets and a promising story to tell shouldn't need to rely on excessively generous warrants and options deals to successfully complete capital raisings.
Australian: Australian companies primarily use options and a summary of these can be found in the annual report or the latest Appendix 3B notice announcements as per the ASX site listed above.
Canadian: The Options/Warrants position is provided in the Quarterly reports which can be found at the following site in the financial statements section: www.sedar.com/search/search_form_pc_en.htm.
3. Net Current position (Cash) (The larger the ratio of Net Current Position to the Market Capitalization of the company the better)
Cash is the life blood of any junior mining company. When buying a position in a company, it is important to ensure there is enough cash to fund near term (12 months at least) activities. (If you are unsure email the company) Neglecting to take this into account leaves you vulnerable to capital raisings. This can have a detrimental impact on the share price, depending on how generous the offer is and the market conditions at the time. If you like a mining junior and they happen to be low on cash, wait for an inevitable capital raising and either participate or buy the shares in the market around the issue time.
Net Current position is a company's Current Assets less Current Liabilities which incorporates its cash position and any money owing from or owing to third parties over the following 12 months. It can be calculated from the Balance sheet in Annual, Half Yearly and Quarterly reports (Use the above websites to find them).
4. Debt (Interest Bearing Liabilities) (The smaller the ratio of Debt to market Capitalization the better)
Debt is not an attractive quality for a mining junior that generates no cash flow and has no near term producing assets. It is rare to see a developing mining company with large quantities of debt but it does happen. Interest costs are a sure fire way to burn existing cash levels at a faster rate than normal. As a general rule I try to avoid early stage mining juniors with debt.
The Balance sheet in the Non-Current Liabilities section (Above websites).
5. Share Valuation Alternatives
There are a number of ways to ascertain whether a mining company is good value. These methods vary vastly in complexity. At the end of the day you have to use a method that you are comfortable with and you can understand. There is no use attempting to embark on complicated levels of analysis if at the end of the day you come out more confused than what you were going in! What's more if you don't understand what you are doing, the result is likely to be dangerously meaningless anyway. The two methods I am going to introduce to you today are poles apart in their respective levels of complexity. The first is relatively simple and can be done I believe by almost anybody. The second method is somewhat more complicated and is based on the method investment houses use when ascertaining the value of a mining company's assets (Optional reading).
- Enterprise Value per Unit of metal in the Ground
This is simply the Enterprise value of a company divided by the quantity of metal its projects have in the ground. If a company has many metals it is determined using the primary one.
Step 1 Calculating Enterprise Value (EV)
The EV of a company is the value the market is attributing to its projects net of any financial assets and obligations the company might have. It is calculated as follows:
Market Capitalization: (Outstanding Number of Issued Shares Multiplied by the Current Share Price)
Australian: Look for the latest Appendix 3B announcement for the respective company using the ASX website above where you will find the latest outstanding number of shares.
Canadian: Look up the latest Quarterly Financial Report using the following website www.sedar.com/search/search_form_pc_en.htm and look for the Share Capital note in the back of the financials.
Alternatively you can go to the company's website and find the information there. www.goldsheetlinks.com is a great website to find a mining company's webpage (Most international mining companies listed).
Net Current Position.
Current Assets less Current Liabilities in the balance sheet found in the latest financial reports as per above.
The Non-Current Asset section of the balance sheet.
Debt (Interest Bearing Liabilities)
Non Current Liabilities section of the Balance Sheet
Step 2 Calculating the primary metal in the Ground
This is a case of looking at each project a company has and adding all the:
The Proven and Probable reserves (If any)
The Measured, Indicated and Inferred resources (Take care to ensure the Measured and Indicated resource recorded is additional and not inclusive of proven and probable reserves.
A company's website in the projects section or the latest annual report.
Step 3 Calculating the Enterprise Value per unit of metal in the Ground
The last step is to take the Enterprise Value (Step 1 Result) and divide it by the Metal in the Ground (Step 2). The resulting number is what you are paying per unit of metal in the ground by buying shares in the company. The theory is the lower this number the better.
I have seen this method used quite extensively and whilst I quite like its simplicity, there are a number of limitations that must be considered. Firstly not all metal in the ground is created equally. An inferred resource is the least reliable category and generally speaking it is not worth the same as measured and indicated resource which is better defined. Some projects have had feasibility studies done proving their economic viability, whilst others have not. Some projects may have more than one metal which can also throw out the accuracy. However, all these things can still be considered when comparing results and simply need to form part of the decision making process. An excellent report I read recently considers these limitations and caters for them by including additional information. I strongly recommend that anyone who wants to learn more has a look at the following: http://silverstrategies.com/story.aspx?local=0&id=2873 (All the work has been done for you already)
- Net Asset Value (NAV) (Optional reading for anyone interested otherwise skip to Item 6)
This method whilst more involved than the first is my preferred due to the fact that it caters for a lot of the limitations we have just discussed. It is calculated as follows:
Step 1 Calculating Net Present Value (NPV) for Project(s)
For companies with projects with at least a pre-feasibility study we can establish an NVP. An NPV is a value calculated by summing a project's expected future cash flows and then discounting them back to present day value using a discount rate that reflects the time value of money. It is perfect for valuing mining projects in that it allows for the differing life span of mines, the variety of metals, the differing metallurgical complexities (That is the metal recoveries) as well as the infrastructural differences of projects (Some projects are in remote locations, some are close to existing infrastructure). It is important to note that the effectiveness of this method like any other method is as good as the information used.
Company announcements using the above websites, or alternatively the company website under the project section. Care must be taken when using company numbers to ensure they have used an appropriate discount rate (8-10% at least) and use consistent metal prices with other companies you are comparing. For this reason I find it preferable to calculate my own NPV's as this ensures consistency in the assumptions used.
Step 2 Calculating a Metal Valuation for Projects (Without feasibility studies)
a different value for each metal (% of spot price) with more value being assigned to better proven measured and indicated resource than the less reliable inferred category. Whilst still very subjective it does at least cater for the variety of different metals as well as the alternative categories. The key here is consistency. Ensure you apply the same rates across all the companies you look at.
The % of the spot price you use is a case of personal preference. RSG Global uses a range of between 2.5 - 4% and considers an array of factors such as physiography, infrastructure and proximity of a suitable processing facility when arriving at the appropriate rate. In a KPMG report I read recently I saw them use 0.5% for inferred; 2% for indicated and 5% for measured (Again these are just indicative numbers).
Step 3 Adding Additional Investments and Net Current Position less Debt (Interest Bearing Liabilities)
The next step is to add any Investments to the Net Current position and then subtract any debt to arrive at what the company is worth aside from its projects. You use the same information we used when establishing the Enterprise Value of the company.
Step 4 Establishing the Net Asset Value
The last step is to add the dollar values of Step 1, Step 2 and Step 3 and divide the result by the total number of outstanding shares to arrive at the Net Asset Value.
Generally speaking the closer a company's project is to a production stage, the more likely it is to trade closer to its NAV or a multiple of its NAV. Companies with projects in varying stages of the feasibility study process will generally trade anywhere from 20 - 75% of their NAV. I want to emphasize that these numbers are more useful for comparative purposes than coming up with useful target prices. I like to take between 3 - 6 comparable companies and establish an average discount/premium to NAV. By doing this you can pay closer attention to the companies that trade at a substantial discount to the average.
6. Mineral diversity (The more variety the better)
By speculating in companies that are developing projects with mineral diversity you mitigate a lot of the risk associated with dealing in a single metal. A company that develops a Gold/Copper prophyry deposit for example can have as much as 50% of its value in Copper and 50% in Gold. This means any underperformance in the Gold price can be negated by stronger copper prices and vice versa. Alternatively the company may be developing a number of projects with differing mineral emphasis.
7. Project diversity (The larger the number of projects the better)
For the same reasons that dealing in one metal can be risky, developing a sole project can also be risky. A company that is in the process of developing many projects will not be nearly as detrimentally affected by an unexpected event as say a company that has put all its eggs in one project. Therefore targeting companies with a wide array of projects can also be beneficial.
8. Trading Liquidity (The larger the average number of shares traded the better)
Many of the junior mining stocks trade in a thin market. This is what creates the excessive volatility you see in stock prices. If a relatively large holder decides to sell and there isn't the market to absorb the shares, you quite often see violent fluctuations in share prices. This can be un-nerving if you are a shareholder but at the same time creates wonderful opportunities for the observant speculator. Generally speaking the more liquid a stock is the better (Easier on your nerves!!).
9. Administration costs (The smaller the Administration costs as a % of Market Capitalization the better)
This is something I like to follow in order to gain a perspective on whether a company is cost conscious. If the ratio turns out excessively high by comparison to similarly sized companies I will investigate further. Salary and Wages is usually the big ticket item.
Found in the Profit and Loss Statement in Annual, Half Yearly and Quarterly reports.
10. Political and Environmental Protection Risk
Obviously all projects are not created equally. Some are in politically safe countries like Australia, Canada and the United States whilst others are in areas which are less politically stable. This needs to be considered because on a valuation basis, companies that have projects in Uzbekistan trade at a discount to similar companies with projects in Canada and probably always will. Alternatively, environmental constraints also need to be considered, as many developed countries have very strict environmental standards. (In my experience the two types of risk can often negate each other out.)
11. Hedging Commitments (Smaller the ratio of hedged metal to mineable reserves the better)
This becomes relevant when looking at producing or near term producing companies. Obviously with Gold prices at levels substantially below fair value (See www.gold-eagle.com/editorials_05/schwensen110205.html), you want to invest in companies that can take full advantage of the anticipated price appreciation. The reality is banks that finance the development of many of these projects insist on a portion of the future production being hedged. You need to look for companies with minimal hedging. On average Australian producers have 20-25% of their reserves hedged (Very annoying!!)
12. Management (The more experienced the better)
I mentioned in my previous article that the management of a company was one of the most important factors. Unlike the other key components, management is not something that is easily quantifiable. Being able to assess management comes from experience in the industry. I like to ask the following two questions:
- What is the company ultimately trying to achieve? For example they might be working towards developing a silver mine in Mexico.
- Does the company have a management team that has the experience to achieve this end goal? That is, have they successfully been involved in developing a mine before? Do they have experience working in Mexico?
It's essentially no different to a job interview. You are not going to employ someone to build your house if they are only skilled in one facet of the job such as roofing or brick laying.
If you are still with me congratulations on going the distance!! I hope the factors I have discussed today have given you some insight into applying a fundamental approach to trading mining companies. I appreciate keeping a handle on this sort of information is time consuming and probably beyond many of you due to the usual time constraints of every day life. This is why I have decided to start the free monthly news letter. It will be for anyone who is interested in applying a fundamental approach and will be focused on predominantly Australian and Canadian mining juniors (Not just precious metals). Many of the things I have discussed will make a lot more sense when seeing them applied in real life examples. Again for those that are interested simply drop me an email.
Troy Schwensen CPA
Troy Schwensen is a full time investor/Trader that spent 8 years in the Accounting and Finance industry which included roles with blue chip Australian companies such as Goodman Fielder and Fosters where he spent three years as a Senior Business Analyst. He made a decision to leave this industry in 2002 after discovering a long term opportunity to invest and trade in the precious metals market where he has since used his analytical skills to build a sound working knowledge of the sector and its comprising companies.
No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.