The Black Art of Valuing Mineral Properties Mike Etheridge and Oliver Kreuzer
Outline of Talk A brief review of the VALMIN Code, and of the more common methods used to value pre-development mineral properties. Risk-based valuation method – benefits and limitations
The VALMIN Code The VALMIN Code has provided a sound basis for the procedures and practice of valuing mineral (and petroleum) assets for 15 years. VALMIN “provides a set of fundamental principles and supporting recommendations regarding good professional practice” for the Independent Expert. However, VALMIN is silent on valuation methodology, simply requiring transparency as to how the value estimate was reached. With the VALMIN Code up for review, a key question is whether or not it should go further, and provide clear guidelines for preferred valuation methodology(ies).
Valuing Production We are not considering the valuation of mineral properties with reasonably certain future cash flows (i.e., those in production or with an available feasibility / pre-feasibility study). The DCF methodology for such valuations is well established, although its track record in both independent valuations and feasibility studies is not particularly encouraging. Being more explicit about the uncertainty of input parameters, and using stochastic techniques (e.g., Monte Carlo; @Risk) to incorporate uncertainty should be standard, but are rarely used.
Valuing Mineral Exploration PropertiesSome Background Principles - 1 “A mineral exploration tenement is a highly conditional asset and a certain liability” – Phillip Uttley, pers comm. The high conditionality of the asset reflects the very low probability that a discovery of realisable value will occur on any given tenement. The certain liability is because mineral tenements come with a commitment to spend money.
Valuing Mineral Exploration PropertiesSome Background Principles - 2 All systematic analyses of greenfields exploration over the past 20 years or so mineral exploration returns around $0.80 to $0.90 for every $1.00 spent (e.g., Richard Schodde’s excellent work) So does this mean that, on average, greenfields mineral exploration properties have zero (or negative) value? Not necessarily, but it probably does mean that valuation methodologies that always produce positive values should be questioned.
Valuing Mineral Exploration PropertiesSome Background Principles - 3 There is an accelerating trend for companies to expense exploration expenditure rather than to capitalise it. This is also in line with IFRS This trend should break the nexus between exploration expenditure, past or future, and value. It recognises that exploration is simply a cost of doing business, and, by implication, that value will only emerge from (the unlikely event of) a discovery.
Valuing Mineral Exploration PropertiesSome Background Principles - 4 Risk versus Uncertainty
These two terms are used somewhat differently in different applications, but the following uses / definitions work best for Mineral Exploration
Risk = Probability of Failure = (1 – probability of success) – This is pretty well understood by the investor, but apparently not by the IE who assigns a positive value to every mineral property – portfolio value versus project value.
Uncertainty = a measure of our inability to assign a single value to Risk (and therefore Value) – This is less well understood by investors, and indeed by many IE’s.
Critique of Valuation Methods - 1 Multiple of Previous Expenditure Method Had some substance when it was common for companies to capitalise all or most of their exploration expenditure. A recent, largely voluntary move by some companies away from capitalising exploration expenditure has and will continue to accelerate with IFRS accounting. Despite giving the IE scope to use multiples << 1 to effectively write-down past expenditures, deep discounts are rare. Very rarely yields a zero value, which is at odds with the odds......!!
Critique of Valuation Methods - 2 Joint Venture Terms Method Requires recent JV on like property(ies) Assumes that expenditure commitments are related in some systematic way to the inherent value of the property(ies) Does reflect to some extent market conditions But does not reflect the fact that most properties are put up for JV because the owner puts a very low value on them.......
Critique of Valuation Methods - 3 Comparative Transactions Method Closest to market, and to the underlying “willing seller and willing and informed buyer” principle embedded in the VALMIN Code It is essential that all IE’s who provide valuations have a deep and extensive knowledge of recent transactions, if only to generally inform how they apply other valuation methods. Weakness is the shortage of truly comparative transactions
Critique of Valuation Methods - 4 Kilburn / Geoscience Rating Method It took a mining engineer to inject more geology into the formal / quantitative component of exploration valuation!! Tries to make the subjective more objective via the definition and quantification of geological factors related to the likely presence of a mineral deposit. Weightings used and varied as a proxy for an explicit estimation of risk of occurrence of a permissive mineralising environment. Why isn’t this method more widely used? Too much reliance on judgement?? Too Subjective??
So Where Does That Leave the Investor? With valuation methodologies that are professionally carried out according to the VALMIN Code, but which can and do produce meaningless values. With valuations that ignore the very low base-rate of exploration success With consistent overvaluation of individual greenfields mineral properties, at least in having a non-zero value as the lower bound of the value range. Potential for undervaluation of a well designed exploration portfolio / program.
Expected Value Concept Expected (Monetary) Value is today’s value of a risky future outcome It contrasts with Net Present Value (NPV), which is today’s value of predictable (certain…..??) future cash flows. The purpose of the Expected Value Concept is to explicitly incorporate risk and uncertainty into future value estimation. In the Mineral Exploration context, it is today’s value of an exploration project or portfolio Expected Value = Probability of Outcome x NPV of Outcome
Determining Expected Value in Exploration EMV = ρ * NPV Or, in the Exploration context Exploration EV = ρ * Target Value – Cost of Expln Where ρ = probability of success (or, 1 – risk) Target Value = NPV at decision-to-mine of what you are trying to find, or any other agreed measure, such as Market Value
A Systematic, Probabilistic Methodology Kreuzer et al; Econ Geol, June-July 2008
Based on Robust Decision Tree Analysis with Uncertainty Built-In Via Distributions of Probability & Target Value Estimates
Decision Trees Populated From the Potential Outcomes, & Calculated Back to Current State
Limitations of Expected Value Methodology The main limitation is the high uncertainty in estimating probability of success and most likely target value. As a profession, we are happy to make those judgements implicitly, but are resistant to explicit quantification of our judgement. Why? Are we afraid of the outcome??? Uncertainty can be addressed by using ranges of values for these parameters, and some form of stochastic modelling. There are straightforward software tools available for this (see also Kreuzer et al, Econ Geol, 2008) We can overcome these limitations by more widespread use, and by repeated benchmarking against market transaction values.
Conclusions The VALMIN Code provides a clear and robust basis for the practice and procedure of valuing mineral properties. But should it also be more explicit about valuation methodologies? Each of the most widely used methods for valuing pre-development mineral properties has significant limitations. The fundamental value proposition IS described by the Expected Value method, so why don’t we use it? How to make better probability / value decisions in the face of uncertainty / complexity is arguably the most important commercial skill that mineral explorers, especially those who act as Independent Experts, can learn.