Dear Reader,

The Valuation of Mining Companies - Newsletter #2 of 4

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 have converted into this 4 Part Newsletter Series.  All 4 Newsletters will be filed under the 'SRP Newsletter Archive' Button that can be found on the Home Page of http://StockResearchPortal.com.

Newsletter Index and Release Dates

Mining Company Risk Assessment

The following assumes a 'single project' company.  If a company has more than one project the considerations discussed that are 'project specific' need to be considered separately with respect to each project.  From an investor perspective important timing issues, risk assessment, company information, and an appropriate 'risk related rate of return' ought to be include a large number of common factors.  This Newsletter and Newsletter #3 of this Series discuss many of these factors - in some cases followed by discussion shown in smaller print. On a cautionary note, 'Risk Factors' are fact and circumstance specific, and no list or broad discussion of 'Risk Factors' should or can be considered all-encompassing.

General Factors

1.The proper measurement of current business value is the present value of all future returns, where future returns are taken to be after-tax distributable or re-investable (in company growth) 'free cash flows'.  In the context of a mining project 'free cash flow' typically includes the aggregate after-tax annual cash flow expected to the generated over the life of the project less income tax effected annual sustaining (or 'maintenance', 'no-growth') capital investment, less the after-tax cost of any mine closure and related environmental remediation costs.  Any price paid by an arm's length party pursuant to a pre-production sale of a project can be assumed to reflect the purchaser's perception of the present value of all 'free cash flow' the purchaser expects at the date of purchase to realize from the project.

This value measure is fundamental and should be reflected upon at each stage in the life of a mining project, notwithstanding that prior to mine production there is no possibility of a project generating 'free cash flow'.  During the finding stage and mine and process facilities development stage any such value process typically would assume assessment of the project on a 'stand-alone' basis.  In circumstances where an arm's length purchaser (typically a 'major producer') bids for the project prior to production purchaser 'synergies' or multiple purchaser competition for the project are additional factors that ought to be considered in any value assessment.

Investment Time Frame

1. What is the investment time frame, combined with an assessment of the likelihood and timing of a likely liquidity event in the contexts of:

• an exploration company selling a commercial 'discovered' project to a producer; or,

• a possible takeover by a producer?

In this regard, it is important to know whether it is the company's strategy to grow organically, grow through new property acquisition, grow through company

Stock markets are comprised of traders and investors with varied short term to long-term time horizons.  As a result, in general:

• the shorter period of time the investor intends to hold stock in a particular company, the less that investor is likely to focus on long term macro-economic prospects, industry specific economics and long term commodity cycle prices - and the more they are likely to focus on things such as moving average share prices, share price volatility, and near term changes and volatility in commodity prices.  In contrast, the longer an investor's investment horizon the greater needs to be the investor's ongoing and focused interest on long term macro-economic prospects, industry specific economics and long term commodity cycle prices; and,

• it is important to understand the Board's and Management's strategy in the context of whether they intend to develop an exploration project to the point where it can be sold to an arm's length producer, or whether they intend to build a mine and processing infrastructure.  If management plans the latter it is important to form a view as to whether management has the requisite operating experience, financial acumen and contacts, critical mass (i.e. lack of dependence on one or more individuals), and so on.  It also is important to assess whether mine and plant development themselves result in a wrong risk/reward relationship resulting from permitting problems, mine and plant cost overruns, timing delays, unplanned post-production environmental costs, and so on.

Company Identified Risk Factors

1. What 'Risk Factors' does the company identify in its annual and quarterly corporate filings, including the company's and market's perception as to 'host country' (i.e. the country(ies) where the company conducts its exploration and production activities) political risks, foreign exchange rates, income tax rates, and so on?

The company is obligated to make full disclosure of what it believes to be the risk factors affecting its business.  Accordingly, it is important to review what the company declares to be those risk factors - such disclosure typically being made in the company's annual and quarterly Filings.

Ownership - Share Structure

1. In what jurisdiction is the company incorporated?

The laws in the jurisdiction in which the company (or a wholly or partially owned subsidiary) is incorporated or functions in a partnership or joint venture arrangement may influence both the company's and shareholder (or other form of ownership) rights.

2. What is the company's share structure, and what are the terms and conditions of each class of outstanding shares, options, and warrants?

Review and analysis of these things is important this both from the point of view of understanding the rights and entitlements of each of the company's issued share classes, and the number and exercise price of outstanding options and warrants.  Analysis of the latter indicates possible future share dilution, and the price at which that dilution of existing outstanding shares will occur.

3. Is there a controlling shareholder?  If there is, can the personal circumstances of the controlling shareholder be determined so as to conclude whether he/she/it is to likely to ensure or militate against good management practices and liquidity events?

Where there is a controlling shareholder this speaks to the issues of:

• the management competence of the controlling shareholder if an individual, and if he/she is active in management;

• if an individual, the controlling shareholder's willingness to hire proven management if that is an appropriate 'arm's length' thing to do;

• the controlling shareholder's willingness to give up control if commercial sensibility dictates that should happen; and,

• if an individual, the controlling shareholder's emotional attachment to the company and its projects, and hence his/her willingness to look to a liquidity event if commercial sensibility dictates that should occur.

There is little question that the presence of a controlling shareholder (whether or not an individual) tends to fetter corporate flexibility and liquidity.  This should be reflected by investors in their assessment of investment risk and, all other things equal, should cause them in theory to demand higher returns than they ought to expect from an investment where there is no 'control overhang'.

Project Ownership

1. It is important to know whether the company owns the project outright, or at least has control or contractual control of the project.  If contractual control, it is important to understand the terms of the contract and what jurisdictional law prevails?

If the company does not own or control the project outright it is important from a risk measurement perspective to understand:

• whether the contract terms with a third party partner(s) fetters either the company's operating control of the project or its ability to dictate both the timing and the terms of a 'liquidity event' (i.e. an amalgamation, joint venture, or outright sale of the project); and,

• how the laws in the jurisdiction in which the company (or if the project is owned through a subsidiary or joint venture) operates may influence both the company's and shareholder (or other form of ownership) rights.

Corporate Governance

1. What are the company's Corporate Governance policies and practice, and are they adequate?

Companies typically disclosure their Corporate Governance policies and practices in their annual documentation.  In simple terms the greater the stated strength of those policies and practices, the more comfort shareholders should have in the context of the Board and Management meeting their statutory fiduciary responsibilities.

Management

1. What is the reputation of the members of the Board and each of the Executives for, and fact of, integrity?

The importance of this goes without saying.  Without question, one of the most important factors to consider when assessing risk referable to a (particularly Small Cap) mining explorer or producer is the integrity, quality, knowledge base and experience of members of the Board and Senior Management.

2. Does critical mass exist within the company's management team?.  What plans are in place for management succession planning in the event of the departure or death of a key employee?

In circumstances where there is little or no 'management team critical mass' or 'management succession plan' it follows that there is increased dependency on specific individuals, and hence greater risk than where 'management team critical mass' and a documented management succession plan exists.

3. For exploration companies, what is the Director and Management prior successful 'discoverer' or 'finding' experience?  Is there specific experience of, and related dependency on, one or more individuals for exploration and production success?

Where there is dependency on the experience of one or more specific individuals it follows that there is greater risk than is the case where such 'dependency on specific individuals' does not exist.

4. What is the Director and Management proven 'mine development and operation success' in the case of exploration companies that have a strategy of developing a mineral deposit through to production - importantly, distinguishing between open pit and underground mining experience?

5. Does the company have employment contracts with key executives and if so, what are the terms and conditions of those contracts?

6. What are the Directors and Management terms of reference, contracts, compensation, compensation policies, benefit plans and prescribed retirement age - and how does each of these things impact on Company risk?

In Small Cap companies in particular it is common to find Board and Senior Management compensation to be comprised of comparative low salaries and options that provide incentive to Senior Management to succeed.  Having said that, it is particularly important to assess whether the Board and Senior Management has a reasoned and reasonable balance between their own self-interest and the economic interest of Company shareholders.

7. How many actual dollars has each Board member and Senior Executive invested in common shares of the company?

As a general rule, where Board members and Senior Executives have significant amounts of personal capital invested in shares of a Company, as contrasted to simply holding options on treasury shares, common sense dictates such a commitment is positive for company shareholders because those Board members and Senior Executives then have:

• demonstrated a willingness to invest their own capital beside that of external shareholders; and,

• a personal vested interest in ensuring a balance between the interests of the Board and Senior Management on one hand, and other company shareholders on the other, in the context of prospective granting of stock options to Board members and management.

8. What is the history of stock option grants to directors and officers.  Are they reasonable or unreasonable in the context of such things as annual compensation, the relationship of aggregate outstanding director and officer options to each of:

• total undiluted and fully diluted common shares; and,

• current director and management option policies and practices.

9. What is the history of, and past practice with respect to, stock option replacement grants or stock option re-pricing?

Where there is a past practice of stock option replacement grants or stock option re-pricing that should be viewed with skepticism.

10. What is the extent of management's banking, financial institution, and other important relationships?

11. Do the Board and management have a demonstrated ability to raise capital as necessary with time and circumstance appropriate (i.e. not excessive) dilution of existing shareholder equity interests?

This is particularly important in times of restraint in the lending and capital markets.

12. What is the Director and Officer history of insider trading?

Insider trading patterns need to be looked at carefully and with a 'fair eye'.  If there is a large amount of insider selling in any given period that may well be a cause for concern, just as a large amount of insider buying may signal a company worth seriously researching as a potential investment.  However, if an insider with a substantial shareholding sells a comparatively few shares that may simply mean the vendor had an immediate personal need for some liquidity and a sale of those shares was the vendor's best route to that liquidity.

13. Are any of the Directors or Officers directors or officers of any other Reporting Issuers?

If any of the Directors or Officers are directors or officers of any other Reporting Issuers:

• Are their involvements with those other reporting issuers such that they will be less likely to satisfy their responsibilities to the company because of dilution of their respective time and effort?

• Do any of these relationships or their other business involvements (if any) create or result in the possibility of conflicts of interest?

Guidance

1. Historic management guidance measured against actual results needs to be carefully reviewed, and the reasons for material differences assessed.  It is one thing in the case of:

• An exploration company, if management forecasts a drilling program at the beginning of a current year of 30,000 feet for that year and 27,000 feet is drilled.  It is quite another if only 20,000 feet are drilled and little outside of management's control (weather, labour strikes, etc.) contributed to that.

• A producer, if management gives guidance with respect to mineral production quantities that are significantly less than those actually achieved, and little outside management's control contributed to that.

• A producer, if management gives guidance with respect to capital costs or operating costs that are significantly less than those actually incurred, and little outside management's control contributed to that.

It may be perfectly reasonable to excuse a management that fails to meet one or more of its key guidance numbers by significant amounts in any one year, particularly if that same management has succeeded in achieving or at least not significantly missing its guidance in prior years.  However, if management misses some or all of its guidance numbers by significant amounts for two or more consecutive years that ought to be seen as a serious 'red flag' by investors.


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 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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