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The Valuation of Mining Companies - Newsletter #5 of 7

Today's Newsletter is authored by Ian R. Campbell FCA FCBV.

Ian R. Campbell is a graduate of the University of Western Ontario School of Business Administration, a Fellow of the Canadian Institute of Chartered Accountants, and a Fellow and founding member of the Canadian Association of Canadian Business Valuators.  He is the author of the widely used business valuation texts The Principles and Practice of Business Valuation (1975), The Valuation and Pricing of Privately Held Business Interests (1990), and The Valuation of Business Interests (2001); he also is an Editor of Canada Valuation Service.  He worked actively in the founding of The Canadian Institute of Chartered Business Valuators, and was a director of the Institute from its inception to 1976.  In 1976 he founded Campbell Valuation Partners Limited, where he continues to play an active role.  He has given evidence in Business Valuation matters before most Canadian and Provincial Courts in many of the leading Canadian business valuation related cases. The Canadian Institute of Chartered Business Valuators annually awards the Ian R. Campbell Research Grant in the amount of $10,000 to one or more applicants who provide Business Valuation research topics for consideration.  This Grant was established in 2007 and first awarded in 2008.

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Background
 
I concluded in mid-2005 the U.S.$ was going to fall against other world currencies, and focused on the mining and oil & gas industries.  Much to my surprise, I found little written on 'How to Value Mining Company Shares'.  Having written Business Valuation tests used by many Canadian professionals, I decided to write an 'Electronic Book' dealing with what I think ought to be considered when valuing Mining Companies - which I initially converted into a 4 Part Newsletter Series.  Newsletters #1 and #2 of the Series were e-mailed on June 2 and June 16.  They can be found filed under 'SRP Newsletter Archive' Button on the Home Page of http://StockResearchPortal.com.  Due to length, I elected to split what was going to be Newsletters #3 and #4 into five Newsletters to be e-mailed in accord with the following schedule.  Hence the entire series will be comprised of 7 Newsletters, not 4, all eventually filed under the aforementioned 'SRP Newsletter Archive' Button.


Newsletter Index and Release Dates

Valuation Methodologies - Part #1
 
Topics Discussed in this Newsletter
 
Valuation Methodologies - Introduction
 
Valuation Methodologies - Overview
 
Valuation Methodologies - Caveats
 
Valuation Methodologies - Overview Table
 
Asset Based Methodologies
 
Earnings and Cash Flow Methodologies
  
Valuation Methodologies - Introduction
 
This Newsletter and the next one in this Series canvass the valuation methodologies adopted by stock market investors, stock market analysts, corporate acquirers, merger and acquisition intermediaries, and business valuation experts when they value shares in mining companies.  In these Newsletters the following terms have the following meanings, where each is 'point in time specific':
 
1. Enterprise Value:  The total value of a business including both its interest bearing debt and equity components.
 
2. Equity Value:  The total value of the shareholders' equity of a business, where shareholders' equity is stated at its fair market value, not at its 'book' or 'carrying' value.
 
3. En Bloc Value:  The value of all outstanding shares (or other ownership interests) of a business viewed as a whole.
 
4. Per Share Value:  That portion of the 'en bloc' value appropriately attributed to each class of outstanding share capital divided by the number of shares of that share class that are outstanding at a particular point in time.
 
Valuation Methodologies - Overview
 
Different business valuation methodologies should not be equally weighted, or for that matter considered relevant, for any given valuation purpose.  The primary reasons are:
 

• value conclusions reached by Investors, Investment Advisors and Securities Analysts based only on information in the Public Domain necessarily must be more subjective than value conclusions based on both information in the Public Domain and Insider Information;

• at any given point in time quoted share prices, analyst or investor views as to what an appropriate price for a particular traded security might be, or a takeover price per share for a given public company may all be different;

• the market price of a normal sized trading lot of publicly traded securities may be quite different than a takeover price.  This is because takeover prices typically reflect post-acquisition synergies anticipated by the purchaser; and,

• some valuation methodologies are not useful or applicable when determining the value of some businesses.  For example, cash flow or earnings based valuation methodologies may not be relevant to the valuation of a mining exploration company that has no production assets or revenues, neither operating cash flow nor earnings, and no near term prospects of operating cash flow nor earnings.

That said, where a business generates cash flow and earnings, an en bloc share value (i.e. the aggregate value of all outstanding preference and common shares viewed as a whole) generally is developed pursuant to a Discounted Cash Flow ('DCF') methodology.  Assuming full information access the DCF methodology is the most theoretically sound of all share and business valuation methodologies.  This is because it necessitates careful review of near-term forecasted after-tax discretionary cash flows, which typically results in more informed analysis and valuation judgments than otherwise would be the case.
 
Public Market Participants typically do not have adequate information available to them to complete the same 'fully informed' DCF analysis that Corporate Acquirers are able to.  Accordingly Investors, Investment Advisors and Securities Analysts may adopt valuation methodologies that either are not adopted by Corporate Acquirers, or not weighed heavily by Corporate Acquirers.
 
Valuation Methodologies - Caveats
 
The following discussion is subject to important caveats:
 
1. Any conclusion as to whether a particular valuation methodology is reliable or who does or does not adopt it is fact and circumstance specific.  Accordingly, the categorizations set out in the following table and commentary may be inaccurate in any given fact situation.
 
2. 'Corporate Acquirer' means a corporation that acquires all of the outstanding shares or control of another company where it is able to access all relevant information of the target company pursuant to a detailed due diligence process after executing Confidentiality and Non-Circumvention Agreements.
 
3. 'Corporate Acquirer' in the context of the following discussion does not mean a corporation who makes a takeover bid for a public company or portion of the shares thereof where the 'bidder' has access only to publicly available information with respect to the target company.  In the latter circumstance the 'bidder', typically being a company who expects post-transaction synergies, will have specific knowledge of its synergy 'expectations' and be in a better position to assess the value of the 'target' to it than any analyst not directly advising on the transaction.
 
Valuation Methodologies - Overview Table

Asset Based Valuation Methodologies
 
The Liquidation Value Methodology
 
This methodology develops en bloc equity value where a business is deemed not to be a going concern.  Pursuant to this methodology the liquidation value of each tangible and intangible asset is determined by appraisal or otherwise estimated, and those 'liquidation values' are aggregated.  All liabilities (whether or not recorded on the books of the business) are deducted.  This methodology generally is more theoretical than practical, and is seldom if ever adopted in a going concern context by Corporate Acquirers as a risk measurement tool.  In my experience it is rarely used by itself in a stock market share price context, and typically is not adopted by Securities Analysts.  Having said that, where a company owns assets redundant to its operations and strategy those assets might be valued on a liquidation value (net of income tax on disposal) basis by both Securities Analysts and Corporate Acquirers, and added to what otherwise would be either an enterprise value, an en bloc share value, or a 'proportionate' per share price.
 
The Tangible Asset Backing Methodology 
 
This methodology develops an en bloc equity value.  Pursuant to this methodology the 'value in use' (going concern value) of each tangible and identifiable intangible asset owned by a company is determined by appraisal or otherwise estimated and aggregated.  The liabilities of the business are deducted.  This methodology is the theoretically correct methodology to develop 'net asset value' pursuant to so-called 'peer group' analysis.  However, whereas business owners and those Corporate Acquirers who have executed confidentiality agreements have data available to them to meaningfully adjust reported asset and liability values from their book values for accounting purposes to 'value in use' values, Securities Analysts typically do not have the same depth of information with respect to these things available to them.  In my experience, such comparisons do not tend to be particularly meaningful, and any such comparisons should be carefully assessed before placing any reliance on them. The Tangible Asset Backing methodology may be adopted by Corporate Acquirers and their advisors as a risk measurement tool where:
 
1. The difference between the price paid for a business and the underlying tangible asset backing is taken to be a measure of the 'intangible value component' inherent in the purchase price.
 
2. Intangible assets are thought to be at greater prospective risk than are tangible assets.
 
In my experience this methodology generally is adopted in part by Corporate Acquirers as a basis for post-acquisition financial and income tax reporting purposes, but is not widely adopted by Securities Analysts.
 
The Multiple of Net Assets Methodology
 
This methodology typically is used by analysts to develop stock market price estimates, being equity values.  Pursuant to this methodology multiples of reported net book value (or 'shareholders' equity') are imputed from what are taken to be 'peer group companies' and a comparator based stock market price is developed by applying the average, or some other multiple derived from that analysis, to the net book value (or 'Shareholder Equity') of the subject company.  My experience suggests this methodology is widely adopted by Securities Analysts as a primary valuation methodology when valuing mining exploration companies and companies without cash flow and earnings, and is adopted extensively by them as a secondary valuation methodology in other valuation analysis.  Broadly speaking, absent a very detailed and consistent analysis of the net assets of each 'peer group company' application of this methodology is likely to produce unsound results - and hence ought not as a general rule to be thought 'reliable'.  This is because:
 
1. Application of generally accepted accounting (GAAP) principles by different companies may result in different reported asset and liabilities values for similar assets and liabilities.
 
2. More particularly, at any given point in time the current values of historically acquired assets may be quite different than the carrying value of those same assets - a great deal of which current information typically is not publicly disclosed - or for that matter known at any point in time by company Boards or Managements pursuant to either appraisal or analysis.
 
In my experience this methodology typically is not adopted or relied on by Corporate Acquirers or their Advisers, other than perhaps as a litmus test in the context of attempting to determine whether the public markets are likely to assess an acquisition as accretive or negative to the Purchasing Company's share price.

For a comprehensive discussion of Share and Business Valuation see 'The Valuation of Business Interests', Ian R. Campbell and Howard E. Johnson, The Canadian Institute of Chartered Accountants, 2001, available through the websites of either Campbell Valuation Partners Limited www.cvpl.com, or The Canadian Institute of Chartered Accountants www.cica.ca.
 
The views expressed in this Newsletter are those of the author. The value of shares of a given company is time and fact specific.  The valuation theories, principles, methodologies, observations, comments and data inputs discussed in this Newsletter are of a general nature, and are provided for information and general guidance only.  They should not be taken to include all 'value or price relevant factors'.  Nothing in this Newsletter Post is intended to, nor should be taken to, constitute economic or investment advice.
 
The author(s) of this Newsletter or the owners of Stock Research DD Inc. (the owner of StockResearchPortal.com and StockResearchPortalBlog.com) or their families, entities in which they have ownership interests, and officers, directors, employees, agents, partners, affiliates and partners of Stock Research DD Inc. may beneficially own securities and participate in Private Placements of companies references in this Newsletter.  The fact that a company is referenced or discussed in this Newsletter should not be construed as an investment recommendation with respect to that company or its securities.
 
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