From dirt to dollars – how to value mining companies

Companies that run producing mines have the capacity to generate enormous profits and cash flows. That’s because of the scale of the projects, scarcity of the underlying resource and high barriers to entry.

However, investors need to remember that reported results are always looking backwards. Materials dug out of the ground are also finite. That means mine lives can be limited, and operators need to regularly find new mineral deposits to extract and turn into sellable commodities.

To accurately assess the outlook for mining stocks, the pipeline of exploration and development projects cannot be overlooked. The path to turning a patch of land into a producing mine is long and fraught with risk.

Risk – what you need to know

Digging deeper into the mining process

At the very earliest stage, a mining company might have a license area with evidence of stuff worth digging for. This could be based on a visual interpretation of the land, geological surveys, or the presence of mining activity nearby.

At early stages like this, there’s usually a low probability of commercialization and often a hefty cost commitment to progress this further. Investors should be careful this early on and not place much value on projects at this stage.

To move this to the next stage, where drill targets are defined, goes way beyond the picks, shovels and dynamite of the 19th century, so often depicted in cowboy movies. Techniques applied today include conducting magnetic surveys either on the ground or by air (more appropriate for larger areas).

Geochemical techniques like soil sampling and testing can also be used to assess the likelihood of commercially viable mineral deposits.

The next step might be ‘pitting and trenching’ – the stripping of excess soil and dirt to see a more complete picture of the rock. If the results of these early evaluations are encouraging, the next step would be to drill into the rock itself.

Following that, the core or assays are sent off to a laboratory to confirm the presence of target minerals and metals. Diamond core drilling is the most expensive and reliable method. But for the evaluation of shallower deposits or large areas, other techniques work too.

How to navigate a resources and reserves statement?

The aim of drilling is to establish reserves or resources that meet a recognized international standard. Typically, the closer the drill holes are together, the more confidence there is that valuable commodities are in the ground. Anything in between is a (hopefully) educated guess.

A resource is an estimate of metals and minerals contained in a given area, but reserves imply economic viability and may only cover part of the resource.

It might not make sense for a project owner to spend the time and money to scope out the entire deposit. Instead, it could be better starting with a smaller area so it can get development rolling. They can then choose to drill further at a later date.

It’s not to say value isn’t there. But in the unproven zones, without resource definition, it’s hard to put a number on it. An exploration target based on the information available can still be set out, though. By the nature of mining, more geological information becomes available through the mining process itself.

The two key components of reserves and resources are volume (including waste material), usually set out by weight, and grade, which for precious metals can be expressed as grams (or carats for gemstones) per tonne.

The highest-grade gold mine in the world is Agnico Eagle’s Fosterville Mine in Australia and the average grade is still only 28.13 g/t, below half a percent. No wonder the price is so high. On the other side of the spectrum is iron ore, where deposits can grade well over 50%.

Do higher-grade deposits equal higher profits?

Typically, higher-grade deposits will be more profitable, but it’s not as simple as that.

The grade can value significantly across the deposit. Other factors at play include depth, tax regime, extraction technique/refining and labor costs. Deep underground mines are typically more expensive to build and operate than shallow ‘open pit’ operations where the ore can be extracted using fleets of excavators.

For a proposed mine to be eligible for project financing, or to meet the due diligence requirements of an international mining company, it generally needs to be the subject of detailed feasibility studies. A popular study is metallurgy. This assesses the potential recovery of minerals from the ore, environmental studies and economic modeling.

How to interpret mining companies’ valuations of their own projects?

The output of the financial model looks to establish a project value in today’s money, based on all the projected costs and revenues over the life of the mine. It should include construction and decommissioning costs. This is known as the net present value (NPV) and will vary significantly based on what ‘discount’ rate is used.

Higher rate assumptions are more conservative and generate a lower project value. The rate used is often disclosed in the headlines, with NPV10 for example meaning the project value with an assumed 10% discount rate.

Alternatively, some companies choose to disclose a project’s internal rate of return (IRR) or the annualized return of the project over its life. BHP for example expects an IRR of 12% to 14% on its proposed $5.7bn investment in the Jansen potash project in Canada over its 100 year life (August 2021).

These valuations often bear little resemblance to the company balance sheet. Some companies will recognize exploration expenses as ‘intangible assets’. This is simply a phrase for a company’s non-physical assets and can include the value of a brand or intellectual property too.

If the pace of development and hit rate is low, this could result in the company’s value in accounting terms being overstated. On the other hand, the value of large lucrative projects is unlikely to be fully captured.

What are the biggest risks to this value being delivered?

When it comes to modeling project values, we go by the mantra ‘garbage in = garbage out’ and it’s important to assess the risk to the inputs used. Some comfort can be taken if the NPV is based on the findings of an independent competent persons report (CPR), which is often a pre-requisite for financing and permitting.

You can’t simply assume that the NPV equates to the value that the project can be sold for today. Perhaps the biggest risk is that the project is never even built. Mines require approval from the relevant government agency. This will take into account the environmental impact, as well as the impact on the local community.

For mines to operate successfully, access and energy infrastructure is essential. Remote sites might need roads, grid connections or energy generation to be constructed for example. Mining can in these circumstances be a force for good, often providing much needed employment in remote areas.

However, they can also come with negatives, like deforestation and contaminating water supplies for example.

The permitting process is never a given, and can take several years. Other risks to the project value include commodity prices, labor costs and capital expenditure.

Price risk can be reduced if customers can be contracted in advance through the use of ‘off-take agreements’. But there’s always the chance that recovery rates and grades don’t meet initial expectations.

Political risk is equally important. A country’s natural resources can be highly emotional and can be a key target of populist leaders as exemplified by Bolivia’s nationalization of Glencore’s Colquiri mine in Bolivia in 2012. In more recent times, BHP and Rio Tinto escaped a proposed attempt at nationalization in Chile.

Understand risk – why company size matters

Investor takeaways

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