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Underlying Earnings Capacity

November 11, 2002

This article attempts to explain the difference in valuation methodologies when applied to industrial companies as opposed to mining companies:

How does one "value" an industrial company?
How does one value a gold mine?

The underlying assumptions are VERY different.

Valuing an industrial company

First, one needs to get comfortable in one's mind with a concept called a "cruising speed". Every industrial corporation has its own cruising speed which can be measured as follows:

Net "Maintainable" Earnings Before Interest and Tax (EBIT) expressed as a percentage of Shareholders Funds. ("Maintainable" assumes that all non recurring items - both positive and negative - have been excluded)

This ratio expresses the capacity of a company to earn a pre tax, pre interest return on shareholder funds and this ratio (surprisingly) is typically pretty constant for any particular company when measured over a period of several years - which is why I think of it as a "long distance" cruising speed.

If you then assume a reasonable debt/equity ratio of (say) 33% (ie The proportion of total assets after Trade Creditors which is financed by Debt; and you reduce EBIT by the interest on that debt AND also by tax, you get a figure which can be used to determine the "cruising speed of after tax and interest earnings of that company going forward).

The next issue is to assume a dividend payout ratio. What proportion of after tax and interest earnings is the company going to pay? The amount that is retained, is the incremental amount by which future earnings can be "driven" upwards.

So, in summary, the important questions are:

What is the ratio of maintainable after tax and interest earnings when expressed as a percentage of Shareholder Funds?
What proportion of this number will be retained.

If you assume an "infinite" life of the company, you can project shareholder funds out by (say) 25 years like this

Taking into account the "time value of money', and assuming that "depreciation" is sufficient to fund capital replacement (which is a bit of a stretch), then the value of the business today can be thought of as:

THE NET PRESENT VALUE OF ALL CASH DIVIDENDS PLUS THE

NET PRESENT MARKET VALUE OF THE BUSINESS AT EXIT

In practice, after ten years or so, the net present value of a dollar is pretty small and so you can typically stop at between 7-10 years.

The question is: What is the discount factor that should be used?

A rough and ready method is to assume a multiple of the long bond (30 year) rate, and the amount of that multiple is a function of "risk". Typically, (all theory aside) large corporations can be assumed to need a multiple of three times, and smaller (higher risk) businesses need a multiple of up to five time.

Currently, therefore, at today's long bond rate of 4.792%, the Discount Factor should range between 14.38% and 23.96%

The valuation at exit is usually assumed to be the EPS prevailing at that time multiplied by the long term average of Price/Earnings ratios - which is around 15X.

Obviously, in an inflationary environment, the discount factor is high - because the long bond rate will be high, and this REDUCES the net present value of future income. Conversely, in a Deflationary environment, the discount factor will be low and this will INCREASE the net present value. (Of course, one need to adjust "cruising speed" for inflation if one wants to be pedantic).

Historically, the value of businesses when valued in this particular manner gives rise to a price which, when divided by trailing EPS gives rise to a Price/Earnings multiple; and 15X has historically been the average when measured over a long period.

When you go through boom times, the cruising speed increases and, concomitantly, so does the P/E ratio, and vice versa for soft economic conditions - which is why one should check average cruising speed over a period which takes both economic scenarios into account. (We are about to enter a "go slow" cruising speed zone as Consumers move to pay down their dent levels)

Using some "rough and ready" assumptions regarding cruising speed (I have not seen this number researched for the S&P500), I conclude that the S&P needs to fall between 33 and 50% from its current levels to bring it back into line with values as per the above methodology.

But I stress that my calculations have been based on assumptions which have NOT BEEN VALIDATED.

Valuing a Gold Mine

The methodology for valuing a gold (or any) mine is dramatically different in that the value of the business at exit is ALWAYS zero! This flows from the fact that a mine is a wasting asset, and so Net Present Value calculations can only be derived from dividends.

Of course, the cruising speed of the mine is a function of the commodity (in this case gold) price and, where it is believed that there will be a structural change in the gold price platform (say an increase to $500/oz) then the NPV of the mine can be calculated accordingly - usually using a discount factor of 3 X the long bond rate.

Of course there is also the issue of capital expenditure, and mines typically increase capital expenditure when they gear up to take advantage of a rising commodity price - and some "wild" assumptions could be made here.

What I tend to do is ignore BOTH the gearing up and the capex, and assume that 100% of EPS is paid out in dividends.

So, when you discount (say) Harmony's net after tax profits (assuming a gold price of $325/oz) at 15% p.a., you get an intrinsic "worth" of that mine at around US$10 per share based on their stated costs of extraction.

Alternatively, if you assume a gold price of around $400, then you get a Net Present Value of $15 (its current price).

The problem with Harmony is that it has a high "Sovereign Risk" attaching to it, and so the discount factor should be closer to 5 times the long bond rate, in order to compensate.

Therefore, at its current level, Harmony's share price of $15 is factoring in a gold price of around $500 if shareholders are to demand a return of 24% p.a..

A critically important issue which arises from the above is that P/E ratios have no place in valuation of a mine because every mine has a different life expectancy. By definition, the marginal mines or the short life mines can only command a LOW Price/Earnings ratio.

This fact seems to have eluded some of the enthusiastic protagonists of some marginal mines, who appear to believe that a mine is something like a "magic pudding" and a marginal mine can suddenly become a high profit mine when the price of gold rises. The fatal flaw in the logic of these people is that they assume that "hard to get at" ore will cost the same to extract as the "easy to get at ore", and they also (sometimes) assume that the supply of "hard to get at ore" is infinite.

Yes, a gold "vein" (as understand it) typically extends very deep into the earth's crust, but the deeper you go the more costly it is to extract and, if the ore body is of a low quality (as is the case with marginal mines) then the costs of extracting this from great depth rise dramatically.

In the end analysis, Profit = Sales minus Costs. We should not lose sight of that.

Nevertheless, there is no question that a rise in gold price will benefit the marginal mines more - given that most of these are currently breaking even or losing money.

In my mind, using the "random walk" theory, if the gold price rises then all gold shares will rise in price, and to minimise the "time" related risk I choose to invest in long life mines which are less "sexy" but also less risky that they could go under or run out of working capital before the mine has a chance to benefit from any gold price rise.

My late brother-in-law had a saying which made a lot of sense: "It takes twenty years to become an overnight success". The get-rich-quick folk who believe that investing in marginal mines is the way to go need to recognise that they are not investing, they are gambling on TWO factors: