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Nov 11 2008

The Valuation of Mining Companies – Post #17 of 17

Published by Ian R. Campbell at 7:42 am under Blogroll - Additions/Deletions, Valuation of Mining Companies see Legal Disclaimer.

Background to this Series of Posts

This is the 17th in a Series of 17 Posts that published on this Blog from September 16 to November 11. All 17 Posts can be found under the Blog Category ‘Valuation of Mining Companies’. For previously issued Posts in this Series click here. We hope you find this Post Series useful.

Required Rates of Return on Investment

As a result of the high risks inherent in mining exploration and mineral mining and production, in my view the rates of return investors should seek are much higher at the beginning of the exploration process and through to and including production than are conventional required rates of return. Required rates of return are relevant to, and hence determined at, specific points of time. They can change instantly with mineralization discoveries, enhancements, poor drilling results, quantification of NI43-101 compliant proven and probable reserves, mine permitting, material changes in commodity pricing, and so on.

In my experience conventional ‘starting point’ ‘targeted’ ‘strategic corporate acquirer’ ‘nominal’ (i.e. including consideration of prevailing inflation rates) unlevered (i.e. a pre-levered ‘return on equity’)

after-tax rates of return have for many years fluctuated in a range of 10% - 15% when developing the present value of 100% of the forecasted ‘inflation included’ and ‘synergy included’ after-tax operating free cash flow of an acquisition target pursuant to a discounted cash flow methodology. In recent years (to mid-2008) these so-called ‘hurdle rates’, which are applied by corporate purchasers to forecasted after-tax cash flows that include post-acquisition synergies expected by the purchaser, typically have been in the order of 10% - 12%. A broad management, product and functionality comparison between on one hand an established ‘product based’ target company where such ‘rates of return’ typically are required by sophisticated corporate acquirers on one hand and mining explorers and producers on the other hand are set out in the following table. This table assumes what I would describe as a market functioning under ‘normal market conditions‘ which is not in my view the case on November 11, 2008, the date of this Post, and readers should consider the contents of the following table in that context:

	Conventional Acquisition Target	Early Stage Explorers	Discovery Stage Explorers (early Proven & Probable Resources and Reserves – no feasibility study	Explorers with Significant Proven & Probable Resources and Reserves and favourable feasibility study	Companies in process of converting from explorer to producer (i.e. building mine and processing facilities)	Mining Companies (producers)
Management	Critical mass, little individual dependence	Generally individual dependence	Generally individual dependence	Generally individual dependence	Generally some critical mass, less individual dependence	Critical mass, less to little individual dependence
Product(s)	Proven, market accepted, branded, established customer base	Commodity	Commodity	Commodity	Commodity	Commodity
Plant and Equipment	In place, generally well maintained	Non-existent	Non-existent	Non-existent	Being Developed	In place, generally well maintained
Cost Structure	Reasonably predictable	Reasonably predictable based on exploration program	Reasonably predictable based on exploration program	Reasonably predictable based on exploration program	Less predictable	Reasonably predictable, but dictated by volume
Environmental Liability Risk	Typically low/medium high	Some Risk	Some Risk	Some Risk	Some Risk	Medium/High Risk
Underlying Tangible Assets net of capitalized exploration costs	Generally comparatively high	Cash and little else	Cash plus value of reserves	Cash plus enhanced value of reserves	Higher, and very high if mine and production facilities financed largely by debt	Comparatively high
Operating Revenues	Typically some ability to influence price, or adjust prices over time in step with underlying operating costs	Non -existent	Non-existent	Non-existent	Non-existent	Based on market dictated commodity prices over which producer has no measurable influence
After-tax free cash flow	Yes	No	No	No	No	Yes
% Equity Acquired in Takeover	Typically 100%	Takeover is unlikely to occur	Typically 100% (company or one or more properties)	Typically 100% (company or one or more properties)	Typically 100% (typically at this stage company would be acquired)	Typically 100%
Investor in Marketable Securities	N/A	Typically less than 1%	Typically less than 1%	Typically less than 1%	Typically less than 1%	Typically less than 1%
Required Nominal After-tax Rate of Return on Unleavered Equity	10% - 15% (historic – although latterly 10% - 12%*)	Extraordinarily high – say for example purposes 80% - 90%	Extremely high – say for example purposes 65% - 75%	Very high – say for example purposes 50% - 60%	Higher than conventional – say for example purposes 20% - 30%	10% - 15% (historic – although latterly 10% - 12%**)
Timeframe - Investment Double - Say	+/- 7 years	+/- 1 year	+/- 1.5 years	+/- 2 years	+/- 4 years	+/- 7 years

* during the 2005 – mid-2008 time period.

** during the 2005 – mid-2008 time period, and assuming commodity price cycle and appropriate operating expenses, sustaining and growth capital costs, and working capital requirements are built into the after-tax free cash flow forecast.

An important distinction to be made between takeover transactions and normal course stock market transactions is that in the former purchasers typically reflect expected post-transaction synergies in the forecasts they develop. Thus takeover transaction prices typically incorporate consideration of said synergies, which synergies may be speculatively priced into public market trading prices where a takeover is believed imminent, possible, or likely, but otherwise likely are not factored into public market trading prices to any material degree, if at all. As previously noted, the comparative time frames shown other than in the column headed ‘Conventional Acquisition Target’ (second column from the left) are based on an assumption of normal public market trading price activity. A takeover of each type of public company described in the chart (columns 3-7) in theory should result in an investment ’double’ in a shorter period of time than that set out in the chart.

The discount rates suggested for conventional businesses and mining companies in production are broad benchmarks that are based on discussions with large multi-national and national companies during the 1970 – 2008 time period. In practice, these discount rates typically are not adjusted in a material way except in quite unusual circumstances (e.g. periods of unusually high inflation). Thus in my view they represent a reasonable base from which to benchmark appropriate discount rates in circumstances of either higher or lower risk investments with characteristics or functionality differences significantly different from conventional businesses. Other than the ‘conventional’ stated hurdle rates, the comparative required ‘after-tax rates of return on equity’ suggested in the foregoing table have been selected subjectively and linked subjectively to investment time frames for a ‘required value (or ‘price’) double’, but are almost certainly ‘directionally correct’ in that they reflect the highest risk rates at the time a mining exploration company commences operations, with those risk rates diminishing to conventional rates from the evolution of a mining company from early stage explorer through to becoming a producing mine.

Importantly, where a discounted cash flow methodology is adopted important variables such as forecasted selling prices, prospective cost structure, and sustaining capital investment over the forecast period used to develop the terminal value component of the calculation are reflected in the forecasted results that are discounted. The risk of those forecasted selling prices and forecasted costs proving to be accurate is reflected in the discount rate adopted, as is general market and economic uncertainty. It is also important to understand that when developing the value of a conventional business pursuant to a discounted cash flow methodology (or any other valuation methodology for that matter) an inherent assumption is made that the business will survive to infinity, whereas when valuing a company such as a mining company that is exploiting a wasting asset the discount period adopted is that of the estimated finite commercial life of the mine. This finite life typically is reflected through the adoption of a finite forecast period and is not reflected per se in the discount rate itself.

For previously issued Posts in this Series click here.

Ian R. Campbell has for over 35 years been one of Canada’s best-recognized Business Valuation Experts – see biography on this Blog.

This Series of Posts is reproduced and supplemented in E-Books titled ‘The Valuation of Mining Companies’ and ‘Valuation Methodologies’. Those E-Books can be found under the E-Learning tab in the Main Navigation Bar of www.StockResearchPortal.com. They are reviewed and amended as market conditions change and our experience dictates. Accordingly, we recommend readers of this Blog Series periodically visit www.StockResearchPortal.com and review those E-Books.

For a comprehensive discussion of Share and Business Valuation see ‘The Valuation of Business Interests’, Ian R. Campbell and Howard E. Johnson, The Canadian Institute of Chartered Accountants, 2001, available through the websites of either Campbell Valuation Partners Limited www.cvpl.com, or The Canadian Institute of Chartered Accountants www.cica.ca.

The views expressed in this Post are those of the author. The value of shares of a given company is time and fact specific. The valuation theories, principles, methodologies, observations, comments and data inputs discussed in this Post are of a general nature, and are provided for information and general guidance only. They should not be taken to include all ‘value or price relevant factors’. Nothing in this Post is intended to, nor should be taken to, constitute economic or investment advice. See Legal Disclaimer.

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