So lets have a go at establishing RSG's Enterprise Value. Anyone game to throw up a figure?
Enterprise Value per Ounce
Let me start by defining what an Enterprise Value (EV) is. An EV is simply the Market Capitalization of a company (number of outstanding shares multiplied by the current share price) adjusted to eliminate the effect of a company’s financial assets and its financial obligations (liabilities). You subtract the financial assets which would include items such as (not an exhaustive list):
- Cash and Cash Equivalents
- Accounts Receivable
- Inventories (If a producer)
- Listed and Unlisted Investments where you can readily establish a fair value
- Derivatives (Bought Options and favorable Forward Sales Agreements)
And add the company’s financial obligations including (not an exhaustive list):
- Accounts Payable
- Interest Bearing Liabilities
- Derivative Obligations (Unfavorable Forward Sales Agreements and written option contracts)
- Retirement Obligations
What remains is essentially the value the market is attributing to the company’s non-financial assets or its projects. If you were to look at this diagrammatically it would appear as follows:
http://www.marketsandmoney.com.au/images/dr20101019a.jpg
To calculate an EV per ounce, you simply add up the total number of ounces attributable to the company via its projects and divide this number into the Enterprise Value.
The concept of EV per ounce is by no means a new valuation methodology and it certainly has its critics. Like land is the common denominator in our real estate investment example, gold in the ground is obviously the commonality when looking to compare gold related companies.
Now critics of the EV method will tell you that when using this method you are incorrectly assuming that all metal in the ground is created equally. This is of course a valid criticism if and only if your analysis was to simply stop there. It would be like saying property A is better value than property B because I can pick up the land for a cheaper rate per square meter without taking anything else into account.
Obviously this technique would be completely flawed. For instance, you can’t conceivably take a producing gold mining company and compare its EV per ounce with an exploration company and come to the conclusion that the exploration company offers better value. You would be excluding the costs associated with the development of the mine, not to mention the premium a company receives in the market for successfully developing the project.
My question to the critics of EV per ounce would be why on earth would you stop at just this first step? This limitation can be quite simply overcome by having a large enough number of companies to compare, so that you can isolate the ones that have the most in common (similar development stages) and generate the additional information required to consider the applicable variables. These might include:
- The size of the deposit. Bigger deposits tend to attract a premium due to the higher probability of being developed based on better economies of scale.
- Different resource classifications dependent on drill spacing and economic viability. Reserves both Proven and Probable (supported by economic studies) versus just a resource (no supporting feasibility study work).
- The depth of the deposit. Is it shallow enough for cheaper open cut mining methods? (Generally 150m-200m or ideally shallower) Are there large amounts of overburden that need to be stripped away adding to the cost of mining (stripping ratios).
- The average grade of the deposit. Generally speaking, higher grades are cheaper to produce and attract a premium. If you are mining underground, higher grades become essential due to the additional capital cost associated with underground mining.
- Different economics (cash costs, construction costs, ongoing capital expenditure etc) Useful by-product credits can in turn lower the net cash costs of production. The availability of infrastructure lowers construction costs. For example, access to grid power versus the requirement for diesel generators in remote regions (more expensive). Access to ready built roads and ports versus having to build this infrastructure. Underground mines have higher ongoing capital costs associated with the continuation of underground development.
- The metallurgy (recoverability of the metals). Sulfide deposits generally have lower recovery rates than oxide and require a more complicated extraction process.
- The political risks. A deposit in Zimbabwe would obviously trade at a substantial discount to say the same type of deposit in Australia or Canada.
- The exploration potential on the properties and the probability of future expansion of the deposits.
The precious metals sector is emotionally charged. When you study EV per ounce information on a large scale it becomes very apparent just how much influence market sentiment can have on a company’s valuation.
A simple way to avoid this risk is to have a basic sense of value. Perform a quick EV per ounce calculation and see what you are paying. Compare this to some of the company’s peers and establish whether what you are paying is reasonable. Don’t be the chump that is buying shares off the people that were fortunate enough to get in at the ground level and are cashing out.
One of the single largest limitations with the EV per ounce method is having enough comparable companies and all the associated information you need available to make the process of comparison easy and effective. For the average investor, you may be able to undertake this process for a handful of companies but it is not realistic to compile all the necessary information yourself.
If something like EV per ounce sounds like it appeals to you, my advice would be to find a reliable information service that does the grunt work for you at a reasonable price. Most importantly, you need to find a group that actually use their own information and can properly articulate the optimal way of using it.
Troy Schwensen,
for The Daily Reckoning Australia
(20min delay)