By Don Durrett
The difficulty investing in gold and silver stocks is understanding how to value a mining company. I know, because when I started out I didn’t have a clue and made many investment mistakes. Now I make fewer mistakes and I am much more confident that I am making the right choices.
The starting point for valuing a stock is collecting and analyzing data. You need a checklist of information that you are interested in knowing. This is how you find the red flags which nearly every company has to some extent. A short list of these data points include the stock price, market cap, share structure, amount of resources, ore grade, location, management, timelines/guidance, growth potential, cash/debt situation, cash costs, and valuation. You need these data points and information to utilize a systematic approach to valuing a company. Moreover, you need to look at all of the data points before you will understand the valuation of a company.
There are really only two things to do when you analyze a company. First you want to identify any red flags, and second you want to give it a future valuation. You then combine these two factors to arrive at a rating, which is the upside potential of the stock. The purpose of looking for red flags is that you will use them to adjust down the future valuation.
In this article, I will show you how to find the red flags and how to value a stock. I will also show you how to arrive at a rating, which you then use to identify the upside potential of a stock. I invented this rating system through years of experience, and it works very well at finding undervalued stocks.
My system is a ten-step approach, with the first eight steps analyzing data to find any red flags. The ninth step is to check if a stock is undervalued, and the last step is to give the stock a rating.
When I analyze a stock, I use my systematic approach to determine a potential future valuation, which is defined by a rating. The rating represents the upside potential of the stock. If you use this ten-step method, you will have a good way to filter out stocks that you don’t want to own. Also, once you use this system, when you analyze a company, you will know what to look for.
This system is aimed at identifying highly undervalued gold and silver mining stocks. My personal goal is to invest in stocks with ratings of 3 or higher. A 3 rating is a potential five bagger. My belief is that it is currently better to invest in ETFs, such as SIL for silver miners or GDXJ for gold miners, than companies with ratings of 2.5 or less. In the future, if SIL and GDXJ appreciate significantly in value, then 2.5 rated stocks will become more attractive.
I never envision investing in 2 or lower rated stocks, but you may for high quality income producing stocks. A 2.5 rating is a likely three bagger, and a 2 rating is a potential three bagger. The complete rating chart is presented at the end.
Okay, let’s begin.
You want a company with at minimum a potential flagship property (2 million oz. gold, or 40 million oz. silver). This is the most important criteria for picking stocks. Most of your mistakes are going to be from companies that do not find flagship (or potential flagship) properties. If you invest in undervalued companies with flagship properties, you will likely be rewarded.
It’s okay to invest in a few companies that have small properties if the valuations are very attractive, but don’t make it a habit. Focus on flagships, because you are after growth and small properties are not generally conducive to growth.
The reason why we look for properties with 2 million oz. of gold or 40 million oz. of silver is for the future cash flow potential. At these levels, the cash flow is sufficient to grow the company. For instance, a 2 million oz. property will likely produce about 80,000 to 120,000 oz. per year for 12-15 years. That is both solid cash flow and a long life mine. Anything less, and the potential for growth is limited.
The other benefit of a flagship property is its potential value. Let’s use a hypothetical scenario:
Gold Price: $2,500
Production: 100,000 oz.
All-In Costs: $1,200 per oz.
Cash Flow: $1,300 x 100,000 oz. = $130 Million
Valuation at 10x Cash Flow = $1.3 Billion
Only a high quality company is going to get valued at 10x cash flow, but the potential exists for flagship properties to have very high valuations. This requires two things: cash flow and higher gold prices.
The first thing I always do is check the properties for cash flow potential. Ideally, you want to find a growth focused company that will leverage cash flow from a flagship property to expand production. Future cash flow is what we are after, and large properties have the potential to provide high cash flow. Properties that can add production ounces and resource ounces are what create increased cash flow. This is what will drive the stock price higher.
It’s okay to invest in a company with only one property if the valuation is attractive. However, in order for a company to have significant growth potential it will need to have a pipeline of projects, or exploration potential. Thus, if you can find a company that is highly undervalued and has several pipeline properties, that is usually better than a single property. This gives them a pipeline of potential future mines that are likely not valued into their current stock price. This increases the upside potential of the stock.
When you analyze a company’s properties you want to look at several things. How many ounces are in the ground? What percentage is inferred? What is the ore grade? What is the cash cost of mining the deposit? What is the recovery rate? Where is it located? What is the impact of the location? What is the current exploration program? What is the potential resource size? What is the company’s plan for this property? Are they giving guidance of production? What is the size of the mineralization zone? How much of the property has been explored? Does it have a PEA? If so, what is the IRR at $1,300 gold? As you can see, there are a lot of questions to ask, and you need to answer them all to get a clear picture.
In addition to checking out the properties, always check to see if they own them 100%. It’s not a requirement that they own 100%, but if it is less, then you need to reduce the valuation. I usually check their regulatory reports to find out their ownership stakes (Canadian traded stocks can be found at www.sedar.com and American traded stocks can be found at www.edgar.com). It is quite common in the mining business to option properties at a percentage (known as joint ventures).
Ideally you want companies that own their properties and can leverage the increasing gold/silver price for substantial profits. I generally am comfortable if they own at least 75% of their properties; anything less than that and I feel like the upside potential is constrained. With project generators you are going to get much less than 75% ownership. However, they can own dozens of properties which makes small ownership interests acceptable.
One final comment on properties. You want long-life mines because once a mine stops producing, cash flow dries up. This will have deleterious effect on the stock price. For this reason, you need to check the mine life of each project/deposit. Ideally, you want to have at least a remaining ten-year mine life. This will ensure that the cash flow multiple is not severely impacted. For instance, if you invest in a company with a single project that has a short mine life, the cash flow multiple (discussed in step ten) is likely to remain below three and perhaps as low as 1x the market cap.
There are two types of management teams. The first type is an exploration team. This is a company that only knows how to find gold. These are Project Generators. They are called that because they find mines and generate projects for other companies to develop into a mine.
Note that sometimes companies call themselves exploration companies, but their intent is to either option the property or sell it. They have no intention of building and operating a mine. In essence, these are Project Generators, but they do not call themselves that.
The other type is an exploration and development team. These are the management teams I am after. I do invest in some Project Generators, but the upside potential is more constrained with Project Generators because they generally only keep 30% or 35% of a project. Thus, it takes two or three large projects for Project Generators to appreciate significantly in value. The benefit of Project Generators is that they are investor focused and tend to keep share dilution down by never spending money building mines. Plus, once a property is optioned, the JV partner generally finances the exploration program, thereby reducing the need to raise cash. Also, a Project Generator can raise cash by optioning properties. These strategies can keep share dilution very low.
Exploration and development companies find, build, and operate their own mines. This gives them the ability to build a small company into a big company. This can create explosive growth in the stock price as the company grows. And the upside potential can be unlimited as they use their cash flow to grow the company.
When you look at management teams, you want to check if they have the ability to build a mine and if they have done it before. You want to check the experience of all members on the team. This will often be available on the company’s web site. One thing I have learned is that teams with a lack of experience tend to sell their projects right before it is time to build the mine. This is a big letdown for investors, because instead of a potential 500%+ return, you end up with around 50% (which is the going premium for takeovers).
I prefer management teams with good reputations and track records, and who are investor friendly. To identify companies that are investor friendly, first check the share structure (I will be discussing this in step 3). Low share dilution is a telltale sign that companies are looking after shareholder interests. Note that if a company is not a producer with cash flow, or a Project Generator, then they will likely be diluting the share structure to raise cash to fund exploration or development. The second thing to look for is the percentage of ownership in the company that management owns. A high percentage (at least ten percent) will ensure they are shareholder focused.
Management experience isn’t as important for micro cap exploration companies (under $20 million market cap). For these companies, you just want good drill results and a smart geologist. However, once a company decides to build a mine, or if a company is already a producer, then the management team is vital. The reason why is because it is such a difficult industry. It is very easy to make mistakes in this business. Smart management teams are not easy to come by and you cannot expect all of your stocks to have one.
It is a good idea to do some research on the management team and CEO before investing in a stock. Listen to an interview with the CEO and see if you get a good feeling. And if they have a good management team, they will brag about their people. Also, if the CEO is excited about their company’s potential (and they should be), it will be apparent in the interview. I prefer companies that have a CEO who is passionate about their prospects.
A good example is St Andrew Goldfields. They have a strong management team to go with excellent projects in an ideal location. They have the trifecta. These are the stocks you look for, and when you find them, you invest. People and projects are excellent starting points for analyzing stocks, but not the end all. You still have to look at all of the data points to get a clear picture.
One last point is the size of the team. When you do the analysis of small exploration companies, you will learn to differentiate the size of the management team. If it is a small team, what are the odds of them bringing the deposit into production? Very low, in my opinion. This is the difference between a very small exploration team, and a larger company with a lot of experience.
The share structure is broken into three parts:
Outstanding Shares are what you see published when you get a stock quote on Google Finance. These are the common shares that have been issued.
Outstanding Options are stock options given to employees, contractors, or others who are affiliated with the company. Each option has a specific price threshold, along with exercise and expiration dates, which must be met before the stock can be issued. Legally, stock options must be granted at or above the current stock price. If an option exceeds the strike price, they are usually exercised by the option holder and become common stock, thereby increasing the number of shares outstanding.
Outstanding Warrants are options that investors hold to purchase common stock at a specific price for a certain period of time. These are generally given to investors when they participate in a private financing. These are used to entice investors to participate in a financing. They can be very valuable if the stock price increases because of leverage. If you own a warrant, and the stock price appreciates in value, you have essentially been given money. You can then either cash in your profit, or buy the stock at the warrant price, and let your profits ride.
Because warrants and options generally turn into common stock, it is advised to use fully diluted shares (common stock, plus warrants and options) to do your stock valuations. I always use fully diluted shares for stock valuations on my website. One lesson that all mining investors learn is that stock prices drop as the stock becomes diluted. Also, stock prices tend to reflect fully diluted shares, as investors anticipate options and warrants turning into common stock.
Anything that increases the number of Shares Outstanding is called dilution. This can happen by private placements, public share offerings, exercised options, and exercised warrants. You will learn very quickly that in the gold/silver mining business that dilution is quite common.
I prefer to own companies that have less than 100 million fully diluted shares, although it is more realistic to average around 150 million fully diluted shares in your portfolio. Note that if you purchase a company with low dilution that does not mean it will remain that way. A company’s current fully diluted shares can only remain static if they have cash flow, a large cash position, or issue debt to obtain cash.
Companies without cash will either have to add debt or issue more shares to raise cash. The reason for this is because the mining business is cash intensive. Exploration, development, and production requires cash. For most exploration companies, their only option is usually to issue more shares and dilute the share structure. Investment banks are not going to loan them money unless the project is significantly advanced.
Try to avoid companies with over 300 million shares, because the share price will not have explosive potential to rise. For instance, if a company has 100 million shares outstanding with a $1 stock price and the market cap rises to $1 billion, then the stock price will rise from $1 to $10. Whereas, if the company has 400 million shares outstanding, the stock price will rise from 25 cents to $2.50. On a percentage basis, the increase will be the same, but psychologically it will appear to be rising faster for the tighter share structure and more investors will jump in.
It isn’t only psychology that favors tight structures, because each share will be more valuable for tighter structures. For instance, if a company has 100 million ounces of silver in the ground and 100 million shares outstanding, then each share will be worth one ounce of silver. Whereas, if there are 400 million shares, each share will only be worth one-fourth of an ounce. This valuation difference can impact the stock price substantially and is attractive to investors.
While you want to avoid stocks with over 300 million fully diluted shares, it is okay to invest in a few highly diluted stocks, if the valuations are very attractive. Just don’t make it a habit. My upper limit is about 400 million, and I do own a few stocks above this limit. Sometimes the valuation is extremely attractive, even with high dilution. The key for highly diluted stocks is what happens if they stop diluting. If a company has high dilution but is beginning production, then it might be a good investment.
Another reason investors loath highly diluted share structures is because of the potential for a reverse stock split. For instance, once stock dilution reaches 500 million shares or higher, companies often do a 5 to 1 or 10 to 1 reverse stock split in order to raise the company’s stock price. This happened a few years ago with Coeur d’Alene Mining. If you adjust their stock price for the 10 to 1 reverse split, it would be trading today at $1.37. That is substantially below their all-time high (about 500%). From my experience, a reverse stock split never seems to be good for shareholders. Although it is good for investors who purchase after the reverse split, because they get a tighter structure.
Always check to see how many fully diluted shares are outstanding. The market cap is calculated using shares outstanding multiplied by the current stock price. However, if a company has a lot of warrants and options, the true current valuation is much higher when you include fully diluted shares. When you buy a share of stock that has a lot of warrants or options, you are really paying closer to the fully diluted price, because those warrants and options eventually dilute the stock price. The invisible hand of the market tends to account for that valuation.
Another invisible hand valuation that can impact the market cap is called the EV, or Enterprise Value. This is the market cap + net debt. This also known as the takeover price, or true value of the company. Because the debt has to be paid back, the takeover price is actually more than the market cap. Conversely, any excess cash makes the takeover price much cheaper. For this reason, a company with no debt and a lot of cash can have a higher market cap than you would normally expect.
I prefer locations that are mining friendly. This can be defined as the ease of obtaining permits; the tax structure; environmental laws; ease of getting claims approved; ability to get infrastructure; and overall political resistance.
Ideally, you want to invest in Canada, but of course not all mines are in Canada. Thus, you will have to take some political risk. Other countries that I consider to be mining friendly include Australia, Brazil, Colombia, Guyana, Mexico, and two states in the U.S. (Idaho and Nevada). The rest of the world makes me nervous. In fact, even Mexico and Nevada make me nervous. However, that does not stop me from investing. I own mining stocks all over the world. I know that some of these will inevitably experience political risk, such as Bear Creek Mining, which recently lost its mining license for one of its mines in Peru.
Severe political risk should be avoided, such as that found in Venezuela, Bolivia, or Ecuador. Other countries that are beginning to show signs of political resistance to mining include Argentina, Peru, and Chile. Also, the continent of Africa as a whole is risky place to invest, especially South Africa. Tanzania, Burkina Faso, and Ghana are the best of the lot, but even these countries offer risk.
As the price of gold rises, it is going to be a lightning rod for political foes of mining. Rising taxes and potential nationalization are real threats for long-term investments in many countries. If economies struggle, gold and silver can be perceived as national resources that belong to the people. As South America turns left politically (and potentially countries in Africa), this creates more political risk towards mining.
After checking whether the location is in a mining friendly place, the next thing to look for is infrastructure. I prefer to invest in companies that have a project in a mining district that has infrastructure in place. If a project is not in a mining district, that is not a deal breaker, but it has significant advantages. Mines in mining districts tend to get built. Moreover, properties with no infrastructure can mean waiting years until production begins, or capital costs that are beyond a small company’s means.
If you analyze a small exploration company and they are exploring a project that does not have road access and is in the middle of nowhere, think twice. The capex capital requirement is going to increase dramatically, as will the cost of mining the project. Also, they likely will not be able to get financing for the large capex requirement, and will have to either JV the project or sell it.
One of the first things to consider about the location is if there is a mine nearby and if it has had any political issues. If there is a nearby working mine without any political issues, then that is normally a green light another mine can be built. In the United States, this does not necessarily apply because the permitting process can be highly contentious and litigation is common.
Always consider the political and environmental risk of a location. There are many factors that can impact mining: taxation, royalties, potential nationalization, permitting, native issues, worker relations (unions), litigation, ecological resistance, etc.
Do not underestimate the impact of local native issues. This is what caused Bear Creek to lose their mining rights at one of their mines in 2011. Recently in Mexico, Indonesia, and the Philippines, companies had exploration drilling temporarily shut down due to onsite protestors. Resistance to mining is common throughout the world, and appears to be increasing. The protests are primarily ecological, although sometimes it is about economics – who gets the money.
The key for finding a good location is to try to limit your exposure to political risk and avoiding infrastructure issues. Depending on how many stocks you end up with in your portfolio, you can expect to lose money in at least one stock because of political issues. And it is highly likely that infrastructure issues will end up costing you money at some point. This will likely occur when you own a stock with infrastructure issues and other investors avoid it, leaving you holding the bag.
I would not advise completely ignoring stocks in politically unsafe locations. For instance, in Africa there are many stocks today that are incredibly cheap. Buying a few them probably outweighs the risk. And having a few stocks in Peru, Argentina, and Chile does not create significant risk. I am leery of Bolivia, although South American Silver and Apogee Silver offer incredibly low valuations and might be worth the risk. It would not be easy for Bolivia to nationalize all of its mines at once, because it would impact many workers.
When I mention growth, I am referring to production growth and resource growth. Without growth in these two areas we are wasting our time. Why? Because production growth and resource growth are vital for stock appreciation. These are the two most important factors that drive a stock price higher, after the price of gold/silver. For clarification, let me explain resources. Resources are composed of three parts:
Inferred Resources. These are resources (not reserves) that have been identified by drilling. Sometimes they are validated with a 43-101 report (if the stock trades in Canada), and sometimes they are estimated by companies. The bottom line is that inferred resources are not guaranteed to ever be mined and should be looked at as potential reserves. Moreover, these are resource estimates that are considered to be unreliable and can be considered speculative resources.
Measured and Indicated Resources. These are resources that have been confirmed to exist. These have been identified with drilling results, and if they are a Canadian traded stock, a 43-101 resource estimate. This is an accredited report by an independent company. These are resources that exist, but cannot necessarily be mined economically.
Proven and Probable Reserves. These are resources that not only exist, but can be mined economically. This is proven using a feasibility study, which is published publically. Once a study is completed, mining companies can announce to investors how many reserve ounces they have.
To arrive at total resources, you add up all three parts. However, this is where you have to use your judgment and confidence in the management team. It is not always prudent to rely on inferred resources. You have to use your judgment when you value a company. Sometimes I will count the inferred and sometimes I will not. One thing that we know is that Measured and Indicated resources, and Proven and Probable reserves exist.
One my website, I use a concept called plausible resources. I count 100% of the P&P, 75% of M&I, and 50% of Inferred to get a total of plausible resources. This is a handy way to get a fairly accurate view of future reserves.
One final point on resources and reserves. Usually when you review a company’s web presentation, they will list the proven and probable (P&P) totals separate. But then they will include them with the measured and indicated (M&I) totals. You have to be careful to check if the P&P reserves are included in the M&I totals. Otherwise you can mistakenly count the P&P reserves twice.
Projecting growth coincides with their properties. What are their projections and guidance for increasing production and resources in the next few years? I like to invest in undervalued companies that are forecasting growth in these two areas. For instance, back in early 2009, First Majestic Silver stated clearly in their company presentation that they were forecasting to produce 10 million ounces of silver by 2012. At the time they were producing about 3 million ounces and were undervalued. I bought it. Why? Because of the forecasted growth. Growth means a higher valuation down the road (as long as gold and silver prices don’t drop).
If a company is not giving guidance for future production ounces or resource ounces, then you have to forecast it yourself. For instance, Calico Resources has a 1.2 million ounce resource and is planning to aggressively drill several targets. The odds are very good that they will double their resources. We can make two forecasts from their drilling program: 1) They will likely double their total resources, and 2) They will likely produce around 100,000 ounces of production in about six years. As a long-term investment, this $14 million market cap company has the potential to be a 50 bagger. That is a very long-term investment, with a lot of risk, but the upside is huge if they make it into production and build the mine themselves.
Note: Rockstar Resources did these same projections and bought out Calico in 2013.
Growth is what creates upside potential, and the very thing that creates growth (increased production and resources) is often not valued into a stock until production approaches. Currently investors tend to ignore pipeline projects that are on the horizon. Until these projects get close to production, the production ounces and resource ounces are not valued into the stock price. Generally, there is spike in the stock price when the final permit is granted to build a mine. Then there is another spike when construction begins. Finally, there is a large spike a few months before production begins.
There are several factors that can hurt a company’s valuation and impact the three main factors. These are location (perceived political risk), infrastructure issues, hedging, high production costs, high energy prices, financial weakness (debt or cash issues), permit issues, environmental issues, native issues, and unexpected events (flooding, mining accidents, legal issues, etc.).
Note that many of these factors are red flags that you can account for when you do a company’s valuation. Be aware that some of the factors are unexpected events that add to the risk of mining company investments. While we can try to project growth, in many respects it is speculation, because we cannot always account for unexpected events that can occur.
When you are looking at projected growth, you need to consider the market cap of the company. Why? Because size matters. A company with a large market cap will not have the same upside potential as a smaller company. For instance, I generally only look at Mid-Tier producers with market caps under $500 million, and preferably closer to $200 million. Why? Because I am looking for big returns and larger cap companies are likely not going to have explosive growth.
You need to determine your own market cap preferences and your investment goals. I recommend avoiding very large companies (except for ETFs and mutual funds), and very small companies. The question you need to answer is what is too big and too small for your investment goals. These answers will vary with every investor.
I recommend companies with market caps below $2 billion and above $20 million. I have found that companies with market caps below $20 million tend to have extensive risk and are highly dilutive. I prefer to invest in companies with fully diluted market caps between $35 million and $150 million. This is a high-risk range, but there are a lot of high quality companies in this range with very high upside potential. This is where you find companies with significant growth potential and very low valuations.
Always check the chart before you buy a stock. How does it look? Is it trending up or down? Is it flat lined? Is it coiled (ready to breakout)? After a reading a few charts by following companies, you will know what to look for. For instance, I watched First Majestic’s chart from 2005 to 2009. It was coiled and ready to break out. How did I know that? Because it was undervalued versus its projected growth and the stock price had not broken out. It continually traded under $3, with a market cap around $200 million. Even the CEO at the time said he was puzzled at the low stock price.
When a stock is undervalued and has not broken out, that is an opportunity. You can either buy it or wait for the breakout. Sometimes it is smart to wait, because there is always the possibility of a market correction (which seems to happen every year for mining stocks) and you can get a better entry price. For instance, if you find a stock you like and the chart is flat lined, why buy it? Why not be patient and see which direction it goes? If you are going to make a long-term investment, it is smart to be patient for your entry point.
When you look at a chart you will begin to see a good chart and a bad chart. A good chart is an undervalued stock that has not yet had a parabolic move. You want to catch stocks before they make big moves. If you see a stock that has already made a parabolic move, then you want to wait for a major correction to get a better entry point. Sometimes you have to admit that you missed the move, and that most of the value has already been built into the stock price.
Stock charts are a handy way to determine a good entry point. Often the stock will show a series of peaks and valleys and will usually trade back to the trend line. Rarely do stocks go straight up after you buy them. For this reason, it is always smart to be patient and wait for a better entry point than on the day you decided to buy it.
In addition to the chart itself, there are other things to check. Does the stock price rise consistently with the gold price? Has the stock price outperformed its peers reflecting investor interest? Are other investors talking about it? In other words, do other investors like it?
I like to buy stocks that other people are buying and talking about. This confirms my valuation and analysis. If I think a company is highly undervalued, I don’t want to be the only person who owns it. I want the stock to be desired and people in chat rooms excited to own it. It makes little sense to invest in a company that is severely undervalued, if no one agrees with you (this is one of the reasons I tend to avoid Bolivian and African stocks). There has to be a reason why people want to own it. In fact, if you find a highly undervalued stock, the odds are good that other people have already found it – and are shouting it to the world somewhere on the Internet.
My two favorite places to find buzz about a stock are The Gold Report (www.TheAuReport.com) and Kitco News Releases (www.kitco.com). The Gold Report has daily interviews with mining analysts. These interviews are read by thousands of mining investors, so what they are recommending is being researched by many people. Kitco News posts the daily news releases by miners. These are also read by many investors. Between these two news outlets, many companies get a lot of buzz – and the good ones get their story out.
The cost structure is the cash cost per ounce and the additional operating costs. To simplify how to calculate profitability, all you need are four numbers: cash cost per ounce, operating cost per ounce, production ounces, and the gold price.
Simplified Gross Profit Calculation:
Production oz. x (Gold Price – (Cash Cost Per oz. + Operating Cost Per oz.) )
For instance, a typical gold mining company today will have a cash cost of $800 per oz., additional operating costs of $400 per oz., and gross profit of $300 per oz. (if gold is $1,500 per oz.). For a 100,000-oz. producer, that is $30 million in gross profit. A low-cost producer would have more profit, and a high-cost producer, less.
I consider the additional operating costs as a method of padding the cash cost. If all of the costs were included in the cash cost, then this padding would not be needed. However, because there are so many hidden costs, such as debt servicing, exploration programs, expansion programs, and even compensation programs, it is necessary to add these to get a better idea of profitability.
Mining companies are now reporting all-in sustaining costs per oz. However, this cost does not include all costs. I have found that the best number for all-in cost per ounce is the quarterly reported EBITA (earnings before interest and taxes). The EBITA number can easily be converted into a cost per ounce.
Ideally you want companies that have a low cost structure and are highly profitable. However, most companies fall into the moderate cost structure category. The companies you want to avoid are those with high costs (which create low profits and high insolvency risk).
An easy way to determine the cost structure of a gold mining company is to divide their cash cost per ounce by the current price of gold. If it is near 1/3, then it is a low-cost producer. Conversely if it is near 2/3, then it is a high-cost producer. If we use a gold price of $1,500 (for round numbers), then 1/3 is $500 and 2/3 is $1,000. Any cash cost below or near $500 is a low-cost structure, and any cost near $1,000 or above is a high cost structure. However, I am a bit conservative and consider a cash cost over $1,000 to be a red flag. If the cash cost is not forecasted to come down, then I will likely avoid a high cost structure (as will other investors).
Note: This same one-third and two-third method works for silver miners.
Factors that increase operational costs include debt payments, exploration, development, and acquisitions. Some companies just don’t know how to make money – even if they have low cash costs. Instead, they waste money building their company through acquisitions and constant expansion, and end up taking on a lot of debt (instead of accumulating cash). Look for companies that are piling up cash and are reporting solid quarterly profits. These are the companies whose stock prices are going to jump. For any producer, we want to see cash accumulating.
Every company will use a portion of their cash for exploration and expansion, but we want them to do it diligently. Often companies are more growth focused than cash focused. When that happens shareholders are never rewarded. A good example of this is Hecla Mining. They had a stock price of $12 in 2008 and today it is $2.74, yet the price of silver has increased and they have very low cash costs. What happened? They took on debt and focused on expansion instead of cash. Hopefully their awful performance as reflected in their share price will change their strategy toward being more cash focused – and investor friendly.
Financing and debt can impact the cost structure. Capex requirements and financing of new mines is a crucial issue for companies that have not yet built their first mine. How they finance their mines can impact the cost structure and profitability of the mine. Often companies are forced to either hedge portions of production (usually at cost) to receive financing. These can be considered outstanding debts and will impact the cost structure and reduce profitability.
One consideration for capex requirements is the ore type. Oxides are fine grain near surface ores that can usually be mined cheaply using leaching. Sulfides are generally mined underground and can be narrow veins. These are much more expensive to mine and the capex is higher. It is smart to consider the capex requirements and the cost structures in tandem when valuing stocks, because both impact profitability.
If a company can build their first mine with a low capex (under $100 million), then that can be a slingshot for future growth. These low capex mines are usually oxide ore surface mines. Another benefit of these types of surface mines is that they can be built faster than crusher mills for sulfide ores.
Often a gold or silver mine will have more than one metal. These extra metals can be counted as cost offsets when they are sold. These offset metals can have a significant impact on lowering the cost of production. For instance, many silver miners can produce silver for a very low cost when they count their offset metal sales. The offset metals can literally pay for the cost of production. Silvercorp and Hecla are two companies with extremely low costs because of offsets with lead, zinc, and copper.
When I do my valuations, I do not include the base metals as part of resources and reserves. However, I do reduce the cash costs somewhat when there are significant offsets. I tend to be conservative when adding value for offsets, because I don’t think that base metals will be in high demand in the future due to potential economic issues. If global economic growth decreases, then base metal demand will also decrease.
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One factor that needs to be included somewhere in your analysis is the timeline risk. This is the amount of time until production begins, or more optimistically when construction begins. Once one of these events occurs, the risk level for the stock drops dramatically and simultaneously the stock price increases. I always consider the timeline risk for companies that are non-producers. I try to use a limit of five years until production, although I can be flexible and go to six or seven years on occasion. As a general rule, if I think production is more than five years away, I will not invest.
Timeline risk can be different for each investor. How long do you want to wait for your investments to pay off? For me, I don’t mind waiting five years, but I don’t want to wait much longer than that. You may have a shorter timeframe in mind and want to see returns in three years. If that is the case, then your timeline risk is shorter. Some of you may not mind waiting up to ten years, and thus have a longer timeline risk. Based on your timeline risk horizon, invest accordingly based on when you can expect future cash flow.
Two other factors to pay attention to for non-producers that are building their first mine are the project’s NPV (Net Present Value) and IRR (Internal Rate of Return). Ideally you want the NPV (at a 5% discount rate) to be significantly higher than the current market cap. A good ratio would be at least 5 to 1. Secondly, you want the pretax IRR to be above 25% at $1,300 gold. If the pretax IRR is below 20%, then that is a significant red flag.
The NPV and the IRR identify the economics of the project. If they are both not solid, then the odds of obtaining financing are not good. Conversely, if they are solid, then the project is likely to get built.
Another thing to compare is the NPV to the capex. You do not want the first mine to have an NPV close to the capex. If they are close, then the project likely won’t get financed. You want the ratio to be at least 2 to 1.
All of these variables can seem confusing, but after you analyze a few stocks and buy a few stocks, they become much easier to understand. There is definitely a learning curve, but after a period of time you will quickly catch on. Knowing if a project is economic; or if the grade is good; or if the stock is highly undervalued; or if it is a good location; or if their is a likelihood of financing issues; will become clear to you after spend some time as a gold/silver mining investor.
Cash is king in the mining business and there are several reasons why. The first is that cash allows for organic growth, whereby a company can self finance exploration and expansions programs. This can be highly valuable to investors because gold can be found in the ground for about $25 per ounce and then sold for $2,500 (in a few years). When a company self funds its growth, it is like manna from heaven for investors. What happens is that growth in resources leads to growth in production, which leads to an increase in the valuation of the company.
The second reason cash is king is because if a company has cash in the bank, this reduces the likelihood of dilution. If a company has a lot of cash, then there is no reason to issue more shares. They can now leverage their cash and issue debt to build another mine. As long as the debt is manageable, then leverage is a wise thing to do. Ideally, you want companies with lots of cash and no debt, or have a plan to pay down their debt quickly after building a mine.
A company that is investor friendly understands what impacts the share price, and understands the value of cash. Often they will state publically their desire to pay down existing debt and increase their cash. Watch how companies manage their cash and debt. You will find out quickly if they are investor friendly and cash focused. Moreover, you want a company that always maintains a significant cash position.
A weak financial position of low cash and/or high debt will hurt the stock price. Often a company will use debt to build a mine and the stock price will drop. This is from the short sightedness and near-term focus of investors today. However, once the debt is paid down, the stock will roar back. The thing to understand about debt is the burden. Can the company manage their debt? Is it a problem? How much is it impacting profitability? Using debt to build a mine is not a problem as long as the debt is manageable.
Allied Nevada currently has $550 million in debt (and high cash costs) and their stock is getting crushed (it came down from $30 to $3). Investors seem to have an aversion to debt at this time. If this trend continues, then you have to invest accordingly, and avoid debt. I like to invest for the long term, and I think that Allied Nevada will pay down their debt and the stock will take off. I own the stock, so I hope I’m right. However, without higher gold prices soon, they could go bankrupt.
Another thing to be aware of is that mining companies without cash flow will often burn through their cash and constantly have to go back and issue more shares to raise money. The amount of cash that is used on a monthly or annual basis is called the burn rate, and can lead to high dilution in the share structure. Companies need cash to fund exploration, development, and expansion. If they can’t get a loan, then they are forced to issue more shares and warrants. This is quite common in the mining business.
Today, stock prices are down dramatically, and many junior stocks are down 90%. For this reason, many of these stocks are going to require large share dilution to raise money. Keep this in mind, if you want to invest in a company with a low share price.
As companies add cash to their bank account it improves their balance sheet. When they are doing this on a quarterly basis, it tends to steadily increase the value of the stock. There is a strong correlation between increased cash and an increase in the stock price. This is especially true in growing companies. As cash accumulates it gives them opportunities to purchase other companies and add to their production and resources.
Today financing and raising money is becoming a significant issue for small mining companies. There are rumors that hundreds of small mining companies could go bankrupt soon because they won’t be able to raise financing to fund exploration projects. This is a significant investment risk and is quite real. This is one of the reasons many small mining/exploration companies are so cheap today. Are they good investments or fool’s bets? It’s hard to say, although I think if you invest in companies that already have the goods (existing flagships or potential flagships), your risk is dramatically reduced.
One question to ask yourself is when is debt a problem. Most companies with debt problems are producers. They obtained their large debt to go into production. For these companies you can check their debt coverage. This is a simple calculation of debt to cash flow:
Cash Flow = Production Revenue minus All-in Costs
(Production oz. x Current Spot Price) – (Production oz. x Cost Per oz.)
Debt = Debt – Cash
(Always subtract cash, since it could be used to pay off debt.)
Debt Coverage = Cash Flow / Debt
If the debt coverage is less than 20%, then you could have a problem if gold prices fall or cash costs increase. It’s always nice to see a debt coverage over 50%. Currently my database has cash flow and debt. I’m working on adding debt coverage as a calculated column.
If you did not identify enough red flags in Steps 1 through 8 to reject a stock, then it is time to check for a low valuation. If the stock has a low valuation, then you can proceed to Step 10, and do the final analysis to obtain a rating.
My favorite valuation method for finding undervalued stocks is Market Cap Per Resource Ounce. I like to use the current fully diluted market cap divided by future reserves. I estimate future reserves based on the number of ounces that I think they will produce in the future. My future reserve estimates are usually very close to their current M&I ounces (inclusive of P&P), although this can vary by company. I use future reserves, because I’m more concerned with the future valuation of the stock rather than the current valuation. I want to buy future reserves really cheap today. Then I will wait for those reserves to get revalued much higher in a few years.
Low Valuation Formula:
Fully Diluted Market Cap / Future Reserve Ounces.
For gold mining companies, you want future reserves to be valued under $50 per ounce. For silver, under $2 per ounce.
These are general guidelines. For gold mining companies you can go as high as $100 per ounce – if you think the company is going to grow – although I would only invest in a few over $50. For silver mining companies, you can go as high as $10. The reason why I am more flexible for silver miners is that I think the price of silver is going to reach $150 per ounce.
If a gold mining company has a current valuation under $50 per ounce for their future reserves, then there is a good chance that those reserves will get revalued in the future much higher, perhaps more than $250. This of course depends on the future price of gold. A solid Mid-Tier gold mining company today can expect their reserves to be valued around $300 to $500 per oz. What will they be valued at if gold reaches $2,500?
My investment goal for gold mining companies is to pay less than $50 per ounce for future reserves. Almost all of my gold investments are in companies with valuations below $50. If my vision is accurate, then many of these companies will end up with their resources (excluding inferred) valued over $250.
Today you can find a lot of gold mining companies with future valuations under $50 per ounce and silver mining companies under $2 per ounce. Once you find these low valuations, check the red flags. Which companies do not have any red flags and have low valuations? Which companies have great properties, are located in safe locations, have good management teams, a nice share structure, growth prospects, low costs, a good chart, and good buzz? As you add up all of the data points, you begin to find your favorite stocks.
Finding stocks with a low valuation is not that difficult. What is more difficult is finding a stock with a low valuation that does not have any red flags and passes all of the checks. This article helps you to identify what to look for by using a ten-step systematic approach.
For producers, another low valuation method is the future cash flow multiple. This is the future cash flow versus the current fully diluted market cap. You want to pay somewhere around 1x cash flow or less. A strong producer should be valued close to a 10x multiple, and weak producer should be valued around 1x. Somewhere in the middle is what you can expect for a solid producer.
Example: Gran Colombia Gold
Stock Price: 95 cents
Fully Diluted Market Cap: $20 Million
Future Cash Flow:
Future Production oz. x (Future Gold Price – Future All-In Cost Per oz.)
350,000 x ($2,500 – $1,400) = $315 Million
Current Fully Diluted Market Cap: $20 Million
Thus, they are trading at a fraction of future cash flow.
The final rating is a combination of a formula and a final analysis. The analysis is a judgment call on your part and will decide how much you like a company. Generally, a low valuation (step 9) and relatively few red flags (steps 1–8) should lead to a high rating.
You can use this ten-step system to rate all of the companies that you analyze. However, if you cannot estimate future reserves, then you have to use a different method to obtaining a rating. I have devised my own method using my experience. For companies for which I cannot estimate future reserves, I do not use any valuation formulas. Instead, I use steps 1–8 and estimate a rating. These ratings are nearly always below a 3, except for some Project Generators.
Ratings are a snapshot in time, reflecting the moment when an analysis is performed. They should be updated at least annually, or when a significant event occurs, such as an updated resource estimate, a feasibility study is released, production begins, or an unexpected event that impacts that value of the stock.
Future Reserves x Future Gold Price ($2,500) x 15% = Future Market Cap
(Future Market Cap – Current Market Cap) / Current Market Cap = Future Market Cap Growth
I use potential future reserves (which I determined in step 9) and an estimated future gold or silver price, which I multiply by 15%. This is my theoretical future market cap. Lastly, I divide the current fully diluted market cap by the theoretical future market cap and arrive at potential market cap growth as a percentage.
Note: While I am using a future gold price of $2,500 and a multiplier of 15%, you can be more conservative. On my website you can set these values to whatever you prefer. Using a future gold price of $2,000 and a multiplier of 10% is much more conservative.
Using this theoretical market cap growth, I give the company a rating (see rating table below). Currently, I only invest in companies that have a rating of 3 or higher, which means they are at least a potential five bagger. Thus, the theoretical growth must be at least 500% or higher for my investments. Many companies today have theoretical market cap growth targets above 1,000%. However, I do not give these companies 5 star ratings unless there are no red flags from steps 1–8.
My future time horizon is 3–5 years. Thus, I am expecting the theoretical growth to occur during this time horizon. However, there are many factors (red flags) that can impact this potential growth target. For instance, some of the red flags include location issues (such as a lack of infrastructure, political risk, permitting, native issues, etc.), weak management, legal issues, capex requirements, production costs, debt/cash issues, hedging, share dilution, and a lack of growth potential.
The final analysis is to reduce the potential theoretical growth based on the red flags. If a company has a potential growth of 1,000%, but has a few red flags then you can’t give it a 4 rating as a potential ten bagger. The question becomes, how much are you going to reduce the rating? Are you comfortable that it will become a five bagger? If so, then you can give it a 3.5 rating. Are you comfortable that it has the potential to be a five bagger? If so, then you can give it a 3 rating. After you begin rating companies, it becomes fairly easy to determine what they should have. If you are not sure, then move them down a rating level.
|1.5||Potential 2 Bagger|
|2||Potential 3 Bagger|
|2.5||Likely 3 Bagger|
|3||Potential 5 Bagger|
|3.5||Likely 5 Bagger|
|4||Potential 10 Bagger|
|4.5||Likely 7–8 Bagger|
|5||Likely 10 Bagger|
After you have a list of companies with ratings, you will have to decide which companies you like the best. Sometimes you will prefer a company with a 3 rating over a company with a 3.5 rating, because of the timeline risk for the full valuation of the stock. Often a 3-rated company will appear much stronger in the near term than one with 3.5 or 4. However, over the long term, the higher-rated companies will likely outperform the lower-rated ones, but in the near to medium term, the stronger lower-rated companies will usually outperform. Often these companies have lower ratings because a lot of the value is already built into the stock, and not because they are not strong companies.
My point is to not overlook the 3-rated companies. It is smart to have a portfolio that is a mixture of strong 3-rated companies and more speculative higher-rated companies.
Let’s do a rating of Gran Colombia Gold.
Current Market Cap Fully Diluted: $20 Million (December 19, 2013)
Projected Future Reserves: 10 Million oz.
Projected Price of Gold: $2,500
10,000,000 oz. x $2,500 x 15% = $3.7 Billion (Projected Future Market Cap)
($3.7 Billion – $20 Million) / $20 Million = 18,000% (Projected Market Cap Growth)
The theoretical market cap growth target is 18,000%, or a potential 180 bagger. This may seem impossible, but they are targeting 350,000 oz of annual production. At $2,500 gold, their annual cash flow could be 350,000 x $1,000 = $350 million. At 10x cash flow they would have a $3.5 billion market cap.
I think they deserve a rating of 3.5, because they are a Mid-Tier Producer and their valuation is ridiculously cheap. However, I cannot give them a higher rating because they are currently losing money and could go bankrupt if gold prices do not turn around soon. Many analysts would recommend selling this stock because it has too much risk of bankruptcy. My thought is that if gold prices turn around soon, this stock is going to take off. It could literally be a ten bagger in a couple of months. I call it the ultimate high risk / high reward stock.
Well, that’s it for now. I would love to hear from you. My contact information is available on my web page: www.goldsilverdata.com. Thanks for reading, and good luck with your gold and silver investments.