Prudent Investor on Mining Misdiagnosis

Prudent Investor says...Caveat!!!

Today, in the business section of the Philippines most prominent broadsheet, a market observer attempted to analyze the mining industry utilizing the traditional financial evaluation tools from where his recommendations where made. I would like to point out that the tools used to evaluate the mining industry abroad have stark nuances to that of the traditional ratios like the frequently used Price-Earnings Ratio. Hence recommendations based on these may be construed as misleading. Find below an excerpt from Investopedia.com on how the Precious Metal industry SHOULD BE evaluated.

Analyst Insight

The price of gold fluctuates on a minute-by-minute basis, so taking a look at the historical price range is the first place you should look. Many factors determine the price of gold, but it really all comes down to supply and demand. Demand typically does not fluctuate too much, but supply shocks can send prices either soaring or into the doldrums.

The difference between production costs and the futures price for gold equals the gross profit margins for mining companies. Therefore, the second place you want to look is the cost of production. The main factors to look at are the following:

*Location - Where is the gold being mined? Political unrest in developing nations has ruined more than one mining company. Developing nations might have cheaper labor and mining costs, but the political risks are huge. If you are adverse to risk (which most of us are) then look for companies with mines in relatively stable areas of the world. The costs might be higher, but at least the company knows what it's getting into.

*Ore Quality - As we mentioned above, ore is mineralized rock that contains metal. Higher quality ore will contain more gold, which is usually reported as ounces of gold per ton of ore. Generally speaking, oxide ores are better because the rock is more porous and therefore easier to remove the gold.

*Mine Type - The type of mine a company uses is a big factor in production costs. Most underground mines are more expensive than open pit mines.

The cost of production is probably the most widely followed measures for analyzing a gold producer. The lower the costs, the greater the operating leverage, which means that earnings are more stable and less volatile to changes in the price of gold. For example, a company that has a cash cost around $175/ounce is, for obvious reasons, in a much better position than one whose cost is $275/ounce. The low-cost producer has much more staying power than the marginal producer. In fact if the price of gold declines below $275/ounce, the higher-cost producer would have to stop producing until the price goes back up. Producers usually publish their cost of production in their annual report; this cost includes everything from site preparation to milling and refining. It, however, doesn't include exploration costs, financing, or any other administrative expenses the company might incur.

Aside from looking at costs, investors should carefully look over revenue growth. Revenue is output times the selling price for gold, so it may fluctuate from year to year. Well-run companies will attempt to hedge against fluctuating gold price through the futures markets. Take a look at the revenue fluctuations over the past several years. Ideally the revenue growth should be smooth. Companies with revenues that fluctuate widely from year to year are very hard to analyze and aren't where the smart money goes.

Investors should keep an eye on debt levels, which are on the balance sheet. High debt puts a strain on credit ratings, weakening the company's ability to purchase new equipment or finance other capital expenditures. Poor credit ratings also make it difficult to acquire new businesses.

As a final caveat (beware), never analyze a precious-metals company based on the price-to-earnings ratio. In general, a high P/E means high projected earnings in the future, but all gold stocks have high P/E ratios. The P/E ratio for a gold stock doesn't really tell us anything because precious metals companies need to be compared by assets, not earnings. Unlike buildings and machinery, gold companies have large amounts of gold in their vaults and in mines throughout the world. Gold on the balance sheet is unlike other capital assets; gold is seen as currency of last resort. Investors are therefore willing to pay more for a gold company because it is the next best thing to physically holding the gold themselves.

There are a few valuation techniques that analysts use when comparing various precious metal companies. The most popular and widely used ratio is market capitalization per ounce of reserves (market cap divided by reserves). This indicates to investors what they are paying for each ounce of reserves--obviously a lower price is better.