Evaluating a Mining Deposit: Resource Overview

When looking at non-producing mining companies with established deposits, investors cannot simply use traditional valuation metrics. Without production, price-earnings ratios, dividend yields and balance sheet asset backing, are not accurate ways of valuing an asset. That's because the real value of these assets are what the industry is willing to pay, or at least, what the market is willing to attribute across the sector.

Take Minera IRL's (LSE:MIRL) Don Nicholas gold asset, which they disposed of in July 2014, as an example. The carrying value of the asset shown on Minera's balance sheet totalled $43.7m, yet they only managed to sell the asset for a net cash price of $11.5m. They will therefore incur a write-down in the value of the Don Nicholas asset, and have an exceptional loss to show on their next set of accounts. This is one of many examples that prove that balance sheet asset valuation methods for mining deposits are quite often far from the value they could fetch in a sale. Therefore, the market does not value the asset at the balance sheet level - rather, at a large discount. This tutorial will seek to examine various basic factors that can impact upon the attractiveness of a deposit, before economic studies have been undertaken.

Factors affecting a Valuation

It is possible to split the main factors affecting the valuation of a deposit into three core categories, as below:

- Country of Operation

This is a key consideration to be made, since it is an umbrella for a whole range of sub-factors. One of the main factors within this is the government and associated legislation. Ideally, the operating environment for a mining company would be positive, with low taxation rates, a stable government (to encourage investment) and perhaps even tax incentives for the mining industry. In reality, that is rarely the case, especially in many low-income countries. For example, various prominent people in countries in Africa have been exposed for corruption and are well known for having unstable governments. Numerous less economically developed countries also have lengthy bureaucratic processes, and this only assists in brewing uncertainty. Therefore, risk premiums are attached to the country operated in. Countries such as Canada and Australia are very friendly mining environments hence attract low risk premiums, whereas countries such as Russia and China attract high risk premiums. That flows through to the value of the asset being at a discount, in most cases.

Country of operation also concerns climate. For example, in locations like Russia, the cold season inhibits many exploration projects - however, in relation to the following points, this is not necessarily a key consideration. Tied in fairly closely is the location of the deposit. If the deposit is located close to infrastructure, then it attracts a value premium. That infrastructure often includes power and water sources, plus rail or road links. The landscape is a further consideration - is the deposit located in an area that is easy to access, and that is favourable for a low cost development - an example may be flat terrain. Or is the deposit located in the centre of a high-altitude mountain range that makes access and development difficult? One of the biggest risks posed to mining companies relates to the environment, and successfully persuading the government that the environmental impacts are not overriding - the bottom line is that if a government or a local community does not want a mine near their location, then developing it is made much harder, and the face value of the deposit diminishes. Final considerations include the exchange rate and overall economic background to the country in question. If the exchange rate is weak, then sales proceeds will be comparatively low when translated back into the reporting currency.

- Mineral Deposit

Fundamentally, the mineral deposit itself is of obvious importance. If the deposit is too small or of too low grade, then it will not be economically viable. Therefore, examining the grade of the resource is crucial, and ideally that will be done alongside other mineral deposits. The grade will depend upon the type of mineral. For gold, grades over 2 g/t are preferable, especially if the resource is large in size. An example of a resource statement is shown below, and is for Ferrex (LSE:FRX).

 
Starting on the right hand side, we have five sub-headings: tonnes, Mn, Fe2O3, SiO2 and LOI. Since the deposit in question is a manganese deposit, we will focus on the column titled 'Mn', which is the chemical symbol for manganese, and refers to the manganese grade as a percentage of the total tonnes. The tonnes column refers to the total amount of rock tonnes. That does not equal the total amount of manganese - after all, a rock is not pure manganese, only a fraction of it is. The grade tells us the number of grams of gold per tonne, and that is shown to be 17.1% and 12.2% for each variety of resource category, respectively.

Using these two numbers, we can derive the number of tonnes of manganese contained within the measured resource rock - in this case it is simple, as we simply multiply the number of tonnes by the percentage as a fraction. Therefore, the calculation is 2,000,000 * 0.171 = 342,000 tonnes. A quick internet search reveals that the current manganese price is $2,200 per tonne, so the in ground valuation of the manganese is 2,200 * 342,000 = $752,400,000. That compares to a market capitalisation of less than £10m for Ferrex. Unfortunately, using in-ground valuations is hence a highly inaccurate way to value the asset - most mining projects don't actually even get mined, hence the in-ground number is relatively useless. We must therefore use other methods. There are a number of important consideration points relating to geology, but those won't be covered in this tutorial. The reality is that most junior miners trade at massive discounts to their potential asset worth due to uncertainty and a lack of economic confirmation - that can be alleviated over time, but requires cash.

A resource estimate is based off a cut-off grade. Whilst they are only preliminary for resource statements, they set out a series of scenarios. A cut-off grade is the level (as a grade) below which it is not economically feasible to mine a deposit. Since a resource estimate does not work with economics, they only give scenarios and not reality. For example, they may give three brackets of cut-off grade for manganese: 4%, 8% and 12%. A 4% cut-off therefore tells us that any part of the deposit that is below 4% manganese is excluded from the resource estimate. That means that the lower the cut-off grade, the higher the possible resource. Further work on the mineral deposit or the application of economic studies helps to identify what cut-off grade should be used in reality.

Perhaps the most important point within this section is the price of the commodity and the future expectations for the commodity. If the commodity has had a struggling price and demand for it is forecast to show in the next few years, then the deposit is unlikely to gain an attractive valuation. On the other hand, if the price is expected to soar, and the current price is fair, then the deposit is likely to gain an attractive valuation. Do note that the other commodities may be very valuable as well, but at the same time they can be problematic.

- Deposit Categorisation

A further area to touch upon are the row headings shown back in the table above. There is a measured resource and an indicated resource row.

As per the table on the right, the confirmed size of a mineral deposit can be split between resources and reserves. There are three levels of resources: inferred, indicated and measured. Measured resources are the most valuable of the three categories since they account for the highest level of geological confidence. This type of resource should therefore be given the greatest attention, and the highest value of the three resource categories.

Further to that, if economic studies are undertaken (these will be covered in a later tutorial), then parts of resources can be upgraded to reserves. If economic studies support a part of the indicated resource to be economically viable (at a particular price of the commodity), then it can be upgraded to reserves status, under 'probable'. If they support part of a measured resource to be economically viable, then it can be upgraded to reserves status, under 'proven'. Therefore, a company could have a 1,000,000 tonne measured gold resource, 500,000 tonnes of which are proven. It is essentially a sub-category. Reserves should be given a much higher valuation than resources, given that they have had economic tests applied. So, if there are two identical companies with identical grades and resource size, and operating in the same country - the company worth more is the one with a more certain category of resources/reserves.

A final consideration for this point relates to how much of the mineral deposit has been drilled. The area over which the mineral deposit extends is called the strike length. If the resource estimate is only based on 2km out of a 10km strike, then investors are likely to attribute a premium valuation. That is because there is the potential for additional resources to be defined. The same theory applies for when a resource is present at depth. However, remember that there are no guarantees that the rest of the deposit will live up to expectations - on the other hand, remember that it could exceed expectations and have high grades.

Establishing a Market-Based Valuation

Using the knowledge above, we can now construct a market-based valuation for a particular resource. Whilst a more detailed valuation can be created through using different values for each type of resource/reserve category (with higher valuations per unit as certainty increases), that is a little more complex, so this will run through creating a valuation assuming indifference between resource types. We can then discount the mineral unit price accordingly - this will become clearer as we follow through an example.

Starting Statistics:
- Total Tonnage = 300,000,000 tonnes inferred. 200,000,000 tonnes indicated
- 100% working and net revenue interests in the project
- Commodity = Iron
- Iron grade = 40% for inferred. 45% for indicated
- Market Capitalisation = £18 million
- Net current assets/liabilities = £3 million
- Non-current debt/borrowings = £0m
- Country of Operation = Canada
- No strategic partner for the assets

1. Calculate the amount of NET (to the company) contained mineral
- Multiply total tonnage by the grade as a fraction of one for both categories of resource:
Inferred tonnes of iron: 300,000,000 * 0.4 = 120,000,000 = 120MT of iron
Indicated tonnes of iron: 200,000,000 * 0.45 = 90,000,000 = 90MT of iron
Total tonnes of iron = 210MT

2. Calculate the adjusted market cap of the company
- Take the market capitalisation of the company and subtract the net current assets (this value can be found on the balance sheet of the company - look for the current assets and subject current liabilities). In this instance, there are net current liabilities of £3 million. Since there are liabilities, add this number to the market capitalisation instead. Also add any non-current borrowings/debt/loan notes. In this case, there are none. We arrive at an adjusted market capitalisation of £21 million

3. Divide the adjusted market capitalisation (in millions) by the total units of resource
- Divide the £21 million adjusted market cap by the total tonnes of iron (in MT). Therefore, 21 / 210 = £0.10. This amounts to the value being attributed by the market per MT of iron. This is a £/unit figure, where the unit is MT

4. Calculate or obtain an industry or sector average for the £/unit figure
- This is perhaps the most complex step in that is requires extensive calculations. There are two ways to go about this - you can either perform the same three steps above for companies within the same stock exchange, or look at other exchanges too. The latter method helps get a more accurate picture, but there may be reasons (e.g. liquidity) why stocks on foreign exchanges may be trading at a very high or low valuation. If you are able to locate a current industry or sector average from a broker note, this step is much easier. Alternatively, just form comparisons with the closest two or three peer companies, rather than 10 or more, as that is much simpler and less time consuming.

From past numbers, I know that a fair average in £/MT for iron is currently around £0.16/MT following a recent decline in the iron ore market and a softening in comparator companies. This asset/company therefore trades at a 63% discount to the sector average of £0.16/MT as it only trades at £0.10/MT.

Can that be justified?

The final step is for us to try and justify that discount. The company has net current liabilities and means that it will probably look to raise cash in the market in the near future as junior miners rarely get access to debt funding. That is a burden that this company has, and means it should trade at a fair discount. However, the company does operate in Canada, so political risks are very low and the iron ore grades are very good. The resource is solely inferred and indicated though, and that means it would be hard to justify any premium to the sector average - it should rather attract a modest discount since the company has not yet defined a measured resource, and it has no strategic partner. However, a £/MT of 0.12 looks fairer than 0.10, hence there is possible 20% upside.

Had the company had the same statistics, but net assets of £1m and a strategic partner in place, then it could well trade at the sector average of £0.16/MT. If it progresses the asset and defines a measured resource, then it could trade above the sector average, and if it ends up defining reserves, then it could trade considerably above the sector average (potentially as high or higher than £0.25/MT).

The final decision you make is essentially a judgement call where you need to weigh up other various factors such as the management team's track record, alongside the deposit valuation. What you have been able to do is define a market-based valuation for the asset, and now you are able to construct a realistic low-case, mid-case and high-case valuation for the asset and therefore, for the company. The next tutorial will look at mining companies who have completed up-to-date economic studies on their assets.