Last week we published the first of two articles on how professionals are able to analyze gold stocks. This second installment comes from Tyler Laundon, one of my top research analysts with Small Cap Investor Pro.
Too many investors buy mining stocks with no idea what they are really worth. We're going to change that by giving you the tools to figure out if that exploration stock is a good buy or not.
Last Thursday I discussed the reasons behind regulation in the mining sector and described, at a high level, this regulatory framework.
Today I'll get into the nitty-gritty and outline the different classifications of gold and silver ounces in the ground, what each is worth and how you can tell if a mining stock is a good buy based on how the market values those ounces.
Admittedly, this isn't the most riveting material. But if you own even one share of a mining company you need to know how valuable 'your' ounces are, so this information is critical.
Since a mining company's exploration efforts take years, the regulatory framework of the Canadian Institute of Mining, Metallurgy & Petroleum (CIM) requires companies to incrementally gather and report the data to you in the form of scoping studies, prefeasibility studies and feasibility studies - and updated versions of any of the above.
This reporting format is a good thing. It provides transparency to the market on an ongoing basis, creates milestones that help a company seek funding, and tells you if a mining project is likely to be profitable - and thus make your shares of stock go up.
Without these checkpoints you'd be flying blind.
The CIM's framework outlines three main categories and two sub-categories for exploration-stage projects. The category each potential ounce falls into depends on the quality, quantity, detail, and interpretation of geological data, and ultimately the level of confidence in this data.
Typically, a miner's goal is to move ounces that fall into a 'lower confidence' category up to a higher confidence category by gathering more data (i.e. drilling) to increase confidence that the ounces can be profitably mined.
This hierarchy of categories creates intense motivation for mining companies to firm up their resource base because higher-confidence ounces typically receive a higher valuation by the market.
While all three main categories are deemed to have some economic value and are worth considering as part of a mining operation, it's the two sub-categories that include the “high value in ground ore.”
If there is one thing you take away from this article it should be this - the CIM's three main categories and two sub-categories, and their definitions, are as follows:
1) Measured Mineral Resource - These are the highest-confidence ounces based on reliable drilling and sampling data.
a. Proven Reserve - The economically mineable part of a Measured Resource that has a determined value as outlined in at least a Preliminary Feasibility Study.
2) Indicated Mineral Resource - There is enough data on grade and quality to conservatively estimate the value of these potential ounces, but there is still some uncertainty.
a. Probable Reserve - The economically mineable part of an Indicated Resource (and sometimes a Measured Resource) that has a determined value as outlined in at least a Preliminary Feasibility Study.
3) Inferred Mineral Resource - Data shows these ounces exist but you can't put an economic value on them without more drilling and sampling.
This couldn't be easier to understand, right? Well, not exactly. But as you evaluate mining stocks it'll make more sense. I adopted this figure from the CIM and I keep it on my desk for quick reference.
One of the things that make this framework confusing in practice is that companies are constantly updating their reports as they try to showcase the economic value. And some ounces can fall into two categories, such as Measured Resource and Proven Reserve, for instance.
This has led the industry to group categories together in a modified way to show a climb up the value chain from Inferred to Measured and Indicated (M&I), and ultimately to Proven and Probable (P&P).
The bottom line is as a company moves ounces up the value chain, they become worth more. And they should - because drilling is very expensive.
So how much are these ounces worth?
Generally speaking, the industry rule of thumb is that inferred ounces are worth $20 per ounce, Measured and Indicated are worth $30 per ounce, and Proven and Probable are worth $160 per ounce.
Now this is a huge generalization, and the law of averages suggests that in reality the values that a company gets for its in-ground ounces are all over the map.
This is where the modifying factors come in, and are often what differentiate an attractive miner from an unattractive one. These include things such as grade of the ore body, method (and associated cost) of the proposed mine, timeline to development, political risk and availability of capital, to name a few.
The easiest way to compare one mining stock to another is to look at a ratio called Enterprise Value per Ounce, or EVO. To calculate EVO, divide a company's ounces into its Enterprise Value (which is simply its market cap plus debt, minus cash and is available on most financial websites). Because market cap is determined by the share price (and thus the market) and the ratio includes cash and debt, the EVO ratio does a fairly good job of stating how valuable the market believes the company's ounces are.
You can do this for all ounces, or break them up into the various categories and industry averages I listed above; $20/oz. for Indicated, $30/oz. for M&I and $160/oz for P&P.
By comparing the values, you can get some sense of whether the stock is trading at a premium or a discount to its peers.
Now if you've read this far, I suspect you have the patience to go out and try this. I also suspect you'll be among the minority - and that's why you'll have an edge.
Take pride in the fact that you're figuring this out on your own. I guarantee that after you do it three times, it'll make a heck of a lot more sense. And you'll get a lot faster at evaluating new stocks as well as understanding new reports from the mining stocks you currently own.
You'll also have the confidence to know if that mining stock you want to buy is a good deal or a rip-off. As time goes on you'll be able to bring some of the modifying factors into the fold, and you'll likely be a much more successful mining investor.
Tyler Laundon, MBA
You can download the CIM's NI 43-101 Standards document here and print it out for future reference. You can also access a PDF of "CIM Definition Standards for Mineral Resources and Mineral Reserves" on the same webpage.
P.S. My colleague Ian Wyatt has recently added an interesting gold stock to his Top Stock Insights portfolio that has a sole focus of paying out dividends to shareholders and has been raising its dividend by 20% a year. Click here to find out the details on this stock he calls "Forever Gold".
04-26-2012 11:41 AM