Multiples analysis is a key component of valuation within Investment Banking and Equity Research as multiples are calculated based on actual market information and each multiple tells a different story about the state of a business. Analysts usually calculate a variety of multiples to determine the worth of a business and compare its performance relative to similar businesses. In most cases, analysts calculate a combination of equity and enterprise value multiples and present the valuation in a football field chart, which shows the valuation range derived from each multiple as well as valuation ranges derived from other valuation methodologies.
Metals and mining investment banking analysts have to update the comparables database whenever there is new financial reporting. This is usually done on a quarterly basis or when acquisitions or other events that will cause a change in the reserve base or production occur.
Usually, the comps file will be one very large Excel file with each company having its own tab. A summary tab will pull data from each of the company tabs to show all of the peers in a table where they can be easily compared – this is standard across most industries.
Where mining differs is that production, costs, and thus cash flows vary greatly depending on the underlying macroeconomic factors and where a project is in the mining life cycle. Economically viable mineral volume in a mine can be classified as the mine’s resources and can be broken down into measured, indicated, and inferred resources. Measured and indicated resources can be further broken down into proven and probable reserves upon the completion of a feasibility study. Any mineral development depends on proven and probable reserves. Costs are determined by number of ounces or pounds mined and can be ascertained from the company guidance. Revenues are much more volatile and difficult to determine as they depend on the recovery grade of the ore, number of ounces mined and the underlying price of the metal. As such, revenues also depend on the exchange rate/FX as most commodities are priced in USD. An appreciating USD is generally good for mining companies, especially Canadian miners who realize their costs in CAD.
Usually, banks will have a FX deck with major currency pairs and a commodity price assumptions deck which will have base, optimistic, and stress scenarios for the price of various metals. This will drive the multiples valuation model. Based on guidance from the mining company and the characteristics of the mine, banks will also build a production profile showing different cases for annual production of each metal along with the costs.
The Price of the Commodity
Future metal prices are difficult to forecast accurately and are normally beyond the control of the individual mine operator. However, they are the most important determinant of revenue and overall value. Therefore, a well-reasoned forecast of demand, supply, and price is in integral part of any valuation.
Mining companies can hedge production using derivative financial instruments to reduce exposure to commodity price risk. A futures strip price is a commonly used term in commodity markets and refers to the sale of a futures strip. Strip pricing refers to the average of the daily settlement for futures contracts over a specified period of time. This is not necessarily a good indicator for where metal prices could be at the specified time into the future, but it can provide producers with a guideline to help them hedge all production and get guaranteed pricing. Banks will usually have a futures strip pricing deck containing all the main metals.
Analysts also use broker’s metals price decks so that there is an agreed upon consensus regarding the future mineral prices. However, these forecasts might be outdated and not reflect new market conditions and fundamentally different from the analysts’ view on the price of the commodity. In such cases, many analysts use reversion to the mean in the price forecasting. The main idea behind this method is that extreme prices are temporary and that a price will have an average price adjusted for inflation.
Analysts can also access a consensus metal price forecasts on Bloomberg if no other guidance is available. This information can be found using the function CPFC <GO>. Below is an example of what a metals price assumption deck and FX deck with relevant exchange pairs might look like.
Incorporating Hedging in Valuation
Comparables with hedging are important as they show what the company is actually doing in real time with regards to their profitability. It also highlights management’s ability to properly predict/manage risks.
If metal prices are locked in, forward looking figures with hedges will give a good indication of what cash flow analysts can expect. If metal prices fall substantially, cash flow measures will not fall that much as only the unhedged portion is vulnerable.
However, since hedges are short-term (usually not exceeding 12 months and rarely exceeding 24 months), bad assets in a falling commodity price environment will still depress the stock as the producer will not see the same cash flow.
Sometimes analysts also look at comparables excluding hedging so they can compare a more apples-to-apples comparison with regards to the operational performance of the business, excluding the interference of management. Hedges do not show a proper comparable story as different management teams may take on different risk mitigation approaches; looking at comps excluding hedge neutralizes this.