Evaluating a Gold Producer

Whether you are looking for a small cap startup gold producer or one of the biggest names in the business there are several things you should look for when trying to pick out the right one for your portfolio.

The quality, composition, breakdown and accessibility of the assets owned by a particular gold miner are very critical; it is not simply about having x million ounces of reserve and y production. The market prefers certain types of mines over others and this will be reflected in the Price/Net Asset Value multiple that the market assigns to a particular company.

Size and production are the most critical when evaluating a specific mine or a producer as a whole. In general 300k oz of gold per year + would be considered a moderate sized mine, with 500k oz and above considered large. Mines below 100k oz of production a year tend to be looked down upon by the market since the economies of scale are not there and smaller mines may be more prone to production problems due to a lower quality of processing infrastructure because of the small scale. The life span of any given mine is based on its reserve base, some of the largest mines in the world can support 10+ years of production at moderate to high yearly production levels.

Location is a critical factor, mines based in politically stable regions such as Canada, U.S. and Australia are preferred to mines located in more unstable nations in Africa and Central Asia. There are several reasons behind this, first being that a stable country/government is less likely to social issues that could impact mining operations (such as were seen in Kyrgyzstan recently). A second reason is regarding infrastructure, constructing a new mine in a remote area in a developing country will most likely require transportation, power, water and communication infrastructure to be setup. These are additional projects which may further delay the completion of a mine. Finally, taxation risk is another concern. Certain jurisdictions tend to be more mining friendly from a tax perspective than others. Recently Australia released a proposal that suggest a very substantial mining tax hike which sent the entire industry in an uproar. Obviously the lower the company’s exposure to a jurisdiction likely to increase taxes the better.

The physical characteristics of a gold deposit also have an impact on the asset’s valuation and thus the company’s value. Grade is perhaps the second most important aspects after the size of the deposit. There are several ways of measuring the total gold deposit contained on a particular piece of property which can make it rather confusing at times. The most accurate measure is usually listed as proven and probable resources. These are resources that are confirmed to be present based on a feasibility study and are economical to extract. The Resources tend to be a broader term, and include deposits that may not be able to be mined currently at an economic profit and/or there are doubts on the grade (concentration) of the deposit. In general when you see a mine that has reserves that are close to the sum of reserves and resources then you know there is usually a limited upside from further exploration on that given property.

Grade is measured in grams of gold per ton of earth (g/t), logically the higher the concentration the better. This leads me to the structure of the deposit, essentially whether it lends itself to some form of open pit mining or underground/shaft style mining. As a rule of thumb you require about 0.8g/t as a minimum cut-off grade for open pit mining and 4-5g/t for underground mining. Generally open pit mines are cheaper, easier to construct and run, however environmental cleanup costs tend to be higher. Underground mines tend to require more complex engineering work and also run the risk of more safety incidents.

Another thing to consider when looking at a specific gold mine or a mining company in general, is the amount of by-product metals it produces. Metals such as copper, silver, and zinc are typically found near or with a gold deposit. Although these metals contribute to the company’s bottom line the market assigns a lower multiple to gold companies with a higher amount of by-product than ones with little to none. The reasoning behind this is that these by-product metals have a much lower price than gold, and that investors get a lower exposure to the underlying movement in gold prices since part of the company’s cash flows are coming from other metals.

When investors look to invest in gold producers many of them typically want a stock that will be strongly correlated with gold’s performance. One thing that should be considered is whether or not the company hedges its gold production. A gold producer usually does this by entering forward/futures contracts to lock in a future price at which they will deliver the gold to the counterparty of the contract. The logic behind entering these contracts is that it reduces the uncertainty surrounding future cash flows. A CEO would look very smart if he/she locked in future production at record high gold prices, however the opposite is also true; making commitments to deliver gold at a price which is below market price can be very painful. Usually investors prefer to see companies with little to no positions on their hedge books. This gives investors control over the direction they want to take on gold prices rather than leave it up to management.

These factors cover some of the most important metrics affecting the value of gold producers. In general one can find that the most renowned companies in the industry rank quite well amongst all these factors along with having very vast reserves and high levels of yearly production.