Due to the speculative nature of the junior mining business model as well as the geological uncertainty surrounding mineral resource estimates, investments into junior mining stocks can offer huge return potential but will also carry an equivalent amount of risk.
How to Value a Junior Mining Company
It is always important to know the value of your investment; however, due to the speculative nature of the junior mining business model, junior companies can be very difficult to value. Before valuing a junior mining company, we first need to understand the three different stages of the junior mining life cycle: exploration, development, and production.
A successful junior mining story will generally start off in the exploration stage and gradually advance its way to production over time. As the company progress through the various stages of its life cycle, it will become “de-risked” and will consequently rise in value.
Companies in the exploration stage do not have any desktop studies or resource estimates completed and are considered to be entirely speculative in nature as their success relies entirely on making a new mineral discovery through drill programs. The most upside (and by far the greatest risk) comes from buying a junior when they are in the exploration stage. Great drill assay results can send a juniors share price skyrocketing but the reverse can also be true. Junior explorers, the green field plays, are the riskiest plays by far. One set of bad drill results can reduce the stock price to rubble, that is, until the company finds another project to work on. If you’re buying into this kind of play make sure the company has another fallback project in its portfolio.
Development-Stage (“Juniors & Intermediates”)
Development-stage companies can be further classified into two types: 1) post-discovery and 2) near-term producers.
Companies in the post-discovery development stage have recently made a discovery but still do not know how large that discovery is. Once the share price has settled back after the initial discovery, the company will then hopefully produce a 43-101 compliant resource estimate to see how large the resource is. Next will come more advanced desktop studied to determine whether or not the resource can be mined economically.
For nearer term producers (those further down the development path towards a mine), you have three possible economic studies, each with an increasing level of confidence about resource estimates and project economics
Preliminary Economic Assessment (PEA) - “what it could be" - examines potential mining scenarios and economic parameters - A PEA or scoping study is an important milestone for a mineral project, it’s the first step in a company’s economic and technical examination of a proposed mine.
Preliminary Feasibility Studies (PFS) - “what it should be” - more detailed than PEA’s and are used to determine whether or not to proceed with a detailed feasibility study. They are also used as a reality check to determine areas within the project that require more attention
Feasibility Studies (FS) - “what it will be” - will determine definitively whether or not to proceed with the project. A feasibility study or bankable feasibility provides budget figures for the project and will be the basis for raising capital to build the mine.
Companies in the development stage carries far less risk than a company in the exploration stage. Since these companies are well advanced along the development path, a lot of the guesswork about grade, size, costs and metallurgy has been taken out of the equation for us. They have done sufficient work to give investors a certain level of confidence that their project will successfully move towards the production stage.
Companies in the production-stage, also called “majors”, are well-capitalized companies usually with decades of history, world-spanning operations, and slow and steady cash flows. Major mining companies are not much different from large oil companies, and many of the same valuation metrics apply, but with a mining twist.
What Valuation Method Works Best? It Depends.
The best way to value a mining company would be with a discounted cash flow (DCF) model. The DCF model takes into consideration all capital costs required to run the mining operation and estimates the amount of future cash flow it is expected to bring in, albeit, discounted by a rate of typically 5%. It is the most comprehensive and detailed valuation model. But in order to build a DCF model, an advanced desktop study (PEA, PFS or FS) must already be completed on the project. So, this really only applies to developers with a completed study and producers, since exploration companies do not have a completed desktop study.
So how can we value exploration companies?
Well, to be frank, valuing a pure-play exploration company is entirely to subjective investor’s perceptions about the prospectivity of the geology on the property itself. Thus, valuation is better-suited for development and production-stage mining companies.
The Best Method for Valuing Development-Stage Mining Companies
The best way to value these is by performing a comparable company analysis (CCA) also known as a “comp” or “relative valuation”. A relative valuation will use a certain metric (usually EV/oz) to derive the value of one company based on that same metric of another, similar company or of the peer group average.
The table below is a very simplistic example of relative valuation of a gold development company.
The metric that we used to derive a valuation in this example is EV/OZ (Enterprise Value / Total Ounces). This is one of the most commonly used relative valuation metrics for development companies as it measures the total current market value of the company divided by the number of total ounces in the ground.
Let's figure out the value of COMPANY A.
First, we need to figure out the Enterprise Value of each company.
Enterprise value (EV) measures a company's total value. It is more comprehensive than using "market capitalization" as it also factors in a company's debt and cash. The formula for EV is as follows:
Next, we need to determine how many ounces of gold each company has in the ground. This can be found by going through a company's investor presentation or website.
For COMPANY A, we get an enterprise value of $69 million and we know that COMPANY A also has 2,010,000 total ounces of gold. Thus, we take the EV and divide by the number of ounces in the ground.
We find that COMPANY A has an EV/OZ of $34.33. This means that COMPANY A is being valued at $34.33 for every ounce of gold in the ground. The peer group average has a much higher EV/OZ of $88.45. The can be so many different reasons for the valuation gap such as permitting issues, jurisdictional risks, management team, head grade, financing risk, etc.
If we were to take the peer group average EV/OZ metric of $88.45 and apply it to COMPANY A's 2 million ounces, then the company would be valued at roughly $177 million or $1.19 per share.
It is important to note that when performing a comparable company analysis, you must only include companies in the peer group that exhibit similarities to each other in terms of life cycle stage, resource size, grade, and geography. They do not need to be exactly the same, but you do not want to be comparing an development-stage company with a production-stage company or your results will be skewed. This is because producers generally trade at much different multiples than developers because they are more advanced-stage and carry far less risk. It would be like comparing apples to oranges.
In the long run, there are really only three possible outcomes for a junior mining company.
Most common is a failure, which leaves a hole in everyone's pocket, including that of the banks and investors. It is often said that only 1 in 1000 junior mining companies actually goes on to become an operating, producing mine.
The second fate occurs when a junior has enough success to justify a major paying a decent premium to gobble it up, leading to decent returns all around.
In the third and most rare fate, a junior finds a large deposit of a mineral that the market wants a lot of – it is a magical combination of the right deposit at the right time. When this happens, juniors can return more in a few days than a major will return in years.