Commentary: How much should you pay for that junior?

The devastation in the junior mining sector is likely to spur some mergers and acquisitions, with larger companies that still have healthy balance sheets going hunting for acquisitions. (See main article: “How to fish for profits in takeover targets,” T.N.M., Vol. 99 Issue 22.) One important criterion that investors should use to evaluate whether a junior may be a target is the valuation of the company.

By comparing three different valuation numbers — the enterprise value (EV) of a target, the reserve value and the discounted cash flow (DCF) for producers, or the net present value (NPV) for advanced projects — with the company’s stock price, investors can identify whether a junior miner is undervalued.

Start by calculating the EV, which is simply the value the market is assigning to the company. To calculate EV, first calculate the number of fully diluted shares outstanding. The fully diluted total is comprised of outstanding shares, plus outstanding warrants and stock options, which generally convert into common stock. The EV is the current stock price multiplied by the fully diluted shares outstanding less any cash (and cash equivalents), plus the total debt. Investors should compare the EV to each of the following valuation figures:

1. Recoverable reserve value: An easy way to value reserves is to add 5% of the measured resource, 2% of indicated resources and 0.5% of inferred, and multiply that number by the spot price of the metal (e.g., US$ per oz.). Always remember to multiply this figure by the forecast metallurgical recovery rate (e.g., 90%), as not all metal will be recoverable from the ore. This will provide an investor with a fair value for the target company’s deposit to compare to the EV.

2. Discounted cash flow (DCF): This calculation is best applied to producing target companies. Cash flow is the term commonly used to measure the net money flowing to the company from its mining operations. Since the company will be receiving this cash spread out over the mine’s lifetime, a discount must be applied to future years. This is because money received in future years is not as desirable as money received today. As a rule of thumb, the discount should be 10–12% per year. A simplified way for an investor to estimate a reasonable DCF figure using a 12% discount rate is to multiply the next full year’s forecasted net cash flow from production by 1.12 of the remaining mine life in years. Investors should look for targets whose share price is 40% or less of the DCF per share. Cash flow estimates are usually shown in feasibility studies.

3. Net Present Value (NPV): If a target company has completed a feasibility study and is nearing production — the fair NPV has normally been established. This figure is usually provided in the feasibility study or on the company’s website. The NPV is a value calculated by summing all of a project’s expected future cash inflows and outflows, and discounting them back to present-day values using a discount rate that reflects the time value of money. It is best to use a 12% discount rate when performing this calculation. In many ways NPV is similar to DCF. Investors should look for targets with share prices less than 30% of NPV per share.

By comparing the reserve value and DCF/NPV to the EV, investors can determine if there is enough upside from the current stock price in the event of a takeover. Investors should buy the target stock at a low enough price to allow for the 38–54% average takeover premium to market.

— Peter Besler is an investment advisor with MGI Securities in Toronto. He can be reached at (416) 594-2257, or pbesler@mgisecurities.com . See his new two-part interview with Mining Markets editor Alisha Hiyate at www.miningmarkets.ca .