Metals & Mining: Alternatives to DCF Valuations in Exploration Projects

Introduction

In this article, I wish to offer a brief synopsis on the use of valuation techniques as applied to exploration projects of junior mining companies, and extend a few thoughts on the generally accepted valuation approaches.

The defining nature of exploration projects, relative to finance, is their great uncertainty. Serious debt financing is virtually unavailable to juniors until after the full-feasibility stage, and for good reason. It is exceptionally difficult to convert even a proven mineral reserve to cash flows, with perhaps as few as one in ten-thousand exploration projects reaching the development stage (1). This difficulty arises from the extreme level of risk at all stages of the project. At the exploration stage, there is primarily geological risk (ore grade, tonnage, and deposit shape, for example); the development stage brings forth geographic/infrastructure risk, as well as enhanced exposure to cycle risk, be it macro-economic or in commodity price; lastly, the production stage is vulnerable to socio-political and metallurgy (processing) risk. There is virtually no point in time where a mining company is not exposed to some, if not significant, amounts of risk. However, it is important to mention here that risk is generally a decreasing function of project development, while certainty and price are an increasing function.

For exploration properties in particular, the extent of the level of risk, paired with the large amount of unknown information, leads to serious problems in valuation. The most widely used method of valuation, the Discounted Cash Flow model, is for all practical purposes useless in light of these characteristics. The inability to model cash flows with any hope of accuracy lasts until at least the pre-feasibility study, where a mining rate, ore grade, recovery rate, and various costs can begin to be estimated. A basic model is offered at this stage; however, an analyst would still be remiss in relying heavily on this model alone due to the the huge uncertainty and risk that still exists within that model. (2).

So what techniques of valuation are available to the mining analyst focusing on exploration properties if the DCF model is generally inappropriate for the task? I will discuss two separate approaches, the cost approach, and the market transaction approach, and offer my thoughts on each.

The Appraised Value Method: A Cost Approach

The appraised value method is “based on the premise that the real value of an exploration property…lies in its potential for the existence and discovery of an economic mineral deposit.” Reasonably justified past costs considered contributory to value, in addition to estimated warranted future costs (sampling of the property, for example), are an approximate determinate of value. These past and future expenditures can be marked down appropriately in the case marginal properties. (3).

This method is suspect due to key flaws in theory, and practice.

Firstly, the method invokes similarities to the cost-of-production theory of value, which has been widely panned by economists in favour of the subjective theory of value (4). And in applying subjective value theory, we can see that the cost approach is not only non-sensical, but also arbitrary. While the aforementioned premise to the appraised value method is true, in what way does the costs involved justify value proportionally? It is true that exploration and drilling costs will eventually reveal the true value of a deposit; but it does not follow that the numeric quantity of those costs have any bearing whatsoever on the actual resource value. Rather it is the metal price, ore grade, and tonnage, among other items, that determine the deposit value as more information is discovered in sampling.

And in practice, we see the absurdity of the appraised value method. Imagine a case where there are two properties with identical geological attributes: one exploration property is extremely conservative in their expenditures, while another is quite liberal, and both properties are consistently finding promising geological developments. According to the cost valuation approach, it is the liberal spending property that will be higher valued, despite the fact that the conservative spender actually has more value in reality.

Thus, in my opinion, the appraised value method should by no means be an appropriate valuation technique for exploration properties. While it may offer some utility as a secondary source of valuation, it should certainly not be relied on primarily.

Comparable Transactions: A Market Approach

The comparable transactions approach estimates the value of an exploration property by sourcing similar projects to determine what the market would pay. The primary weakness in this approach is the drastic variation from property to property in the mining industry. No ore body is identical, which affects cost predictions for infrastructure, socio-political risk, and metallurgy risk, subsequently affecting value in different ways. Because of this impreciseness, the estimation is best conducted in terms of a range, rather than an exact value. The relatively small volume of market transactions at the exploration stage presents another challenge to this approach. This further exacerbates the difficulty in comparisons, as the body of information to benchmark against is fairly limited. Lastly, differing price points in the commodity cycle for when the properties are compared can lead to further inaccuracy in valuations. (5).

That being said, the comparable transactions approach seems to be the more reliable technique for valuation of exploration projects as compared to the appraised value method. Despite its many short-comings, a market approach at least provides some concept of relative pricing points for properties.

But that concept perhaps best illuminates my dissatisfaction with the comparable transactions approach for exploration properties. It is concerned with price, not value. And investors taking this approach leave themselves with no enhanced knowledge of the fundamental value of the property, and furthermore with no true margin of safety.

Conclusion

Overall, while both the cost and market approaches have their use, it would be unwise for an analyst to base his investment policies on these approaches, in my opinion. They ought to be considered secondary tools of which valuations can be referenced to, rather than primary methods in themselves.

Sources

1. https://www.aadnc-aandc.gc.ca/eng/1100100023711/1100100023713

2. http://web.cim.org/mes/pdf/VALDAYLarrySmith.pdf

3. http://web.cim.org/mes/pdf/VALDAYBill_Roscoe.pdf

4. https://en.wikipedia.org/wiki/Cost-of-production_theory_of_value

5. http://web.cim.org/mes/pdf/VALDAYBill_Roscoe.pdf