Considerable thought and effort has been directed towards developing robust standards and methodologies for mineral property valuation but the unique characteristics of each property essentially dictate which of the recognized valuation approaches are most appropriate. Micon was represented on the Special Committee of the Canadian Institute of Mining, Metallurgy and Petroleum on Valuation of Mineral Properties (the CIMVal Committee), and the firm’s experience in independent property valuation has been gained through consulting assignments undertaken on behalf of financial institutions, mining companies and law firms, relating to base and precious metals, industrial minerals, coal and uranium.
In the context of property valuation, the term ‘fair market value’ is defined as the price which is established in a free and open market by transactions between a willing and informed buyer and a willing and informed seller, both of whom are acting without compulsion and at arm’s length. Such perfect markets rarely exist, however. They may be approached in the operations of stock, commodity or financial exchanges where shares or goods of known quality are openly and freely traded between willing and knowledgeable parties. As well, the concept of value carries with it implications of uniqueness in time, that moment at which a willing and informed buyer and seller freely agree on a price.
But there is no market in which the free and open trading of mineral properties provides an acceptable measure of fair market value and properties change hands relatively infrequently. Moreover, mineral properties cover a broad spectrum; at one extreme lie those which are already in production and which have operating histories sufficient to permit reasoned estimation of future operational and economic parameters; and, at the other are properties which might be considered geologically attractive, but on which little or no exploration has yet been undertaken. Between these extremes lies a variety of mineral lands, including those upon which sufficient mineral resources have been demonstrated such that production can be considered, and those at earlier stages of exploration where the existence of an economic deposit remains unproven. Further, each of these properties will have specific physical and economic characteristics which differ from those of any other mineral property.
General Approaches to Valuation
There are three basic approaches to valuation and all depend on the technical knowledge of the valuator:
- Cost approach – based on assessment of contribution of costs to value.
- Market approach – based on comparison of the subject mineral property with the transaction value of similar properties; includes comparable transactions and analysis of terms of option or farm-in agreements.
- Income approach – based on income or cash flow potential of the property.
The applicability of the valuation method depends on the stage of development of the subject property, although there is a degree of overlap:
- Exploration properties – suited to the market or cost approach; income approach not applicable for lack of data.
- Mineral resource properties – suited to the market approach; income approach and cost approach may be applicable in some cases.
- Development properties – suited to market and income approaches; cost approach not suitable.
- Production properties – suited to market and income approaches; cost approach not suitable.
Where an alternate or secondary method is suitable, it should generally be used as a check on the result of the primary method.
The cost approach, also known as the appraised value method, is based on the premise that an exploration property, or a mineral resource property, is worth an amount equivalent application to past exploration expenditures plus warranted future costs to test remaining exploration potential. Technical knowledge and expertise must be applied to the analysis of past expenditures in order to determine which to retain and which to disregard; expenditures that date from more than approximately five years prior to the valuation date are usually excluded. And future costs, represented by an exploration budget to test the future potential, have to assessed for suitability.
Inactive properties are more problematic than those with active exploration; again, the knowledge and experience of the valuator must be applied in order to gain an assessment of the remaining exploration potential which may take account of changes in technology or metal markets, as well as untested targets.
Exploration work that downgrades potential cannot be regarded as productive and, therefore, its cost should not contribute to the assessed value. Clearly, if the property has little or no exploration potential, it has little or no value.
Market Approach – Comparable Transactions
This approach is based on the fundamental premises that there is a recognized open market forum and that there is a standardization of the items traded in that forum. However, because there is no market in which mineral properties are traded and because each mineral property has unique characteristics, the analysis of comparable transactions is not an inherently robust valuation method. Valuation of mineral property by reference to comparable transactions must satisfy three basic requirements:
- The price paid in the comparable transaction was, in fact, an accurate measure of fair market value.
- The resources on the comparable and subject properties have been identified to a similar level of confidence.
- That appropriate adjustments can be made to the price paid in the comparable transaction, in order to compensate for differences between the two properties.
Technical knowledge and experience must be applied by the valuator in order to assess the first two requirements. Parameters which have to be adjusted (such as date, location, climate, status of permitting, comprehensiveness of technical data, among many others) have to be identified and then judgement exercised in order to assess the magnitude of each adjustment.
Income Approach – Discounted Cash Flow Analysis
Provided that sufficient reliable data are available to support the analysis, the income approach – using a discounted cash flow analysis – is the preferred methodology, since it avoids some of the short-comings of the cost and comparable transactions methods.
It is based on the principle that a rational investor will look to the future profits expected to be generated by the property for a return on invested capital. Discounted cash flow analysis is simply a method of relating the initial cash investment to the anticipated cash return. The investor will require not only the return of his original investment, but also a rate of interest thereon that compensates for the perceived level of risk. All future cash flows are discounted back to the date of valuation at that required rate of interest. The sum of those discounted cash flows represents the net present value of the property and represents the amount that the investor would be prepared to pay to acquire the property at the effective date of valuation.
Since the concept of fair market value requires that buyer and seller be not only willing but also informed, in order to perform a robust discounted cash flow analysis, it is necessary to make a separate and informed estimate of each of the factors which will affect future cash expenditure and future cash revenue. Essentially, this means that sufficient data are available to prepare a Feasibility Study, Preliminary Feasibility Study or, subject to applying a higher discount rate, a Preliminary Economic Assessment. For a typical mineral property, these data include:
- The tonnage and grade of the mineral reserves or, where appropriate, mineral resources.
- The annual rate of production which can be sustained from those resources, having regard to the market available for the commodity to be produced.
- The annual cash revenue accruing from the production and sale of mineral commodities.
- The annual cash cost of producing those saleable mineral commodities.
- The annual level of cash income taxes and other taxes to be levied on the profits or, in certain instances, on production or sales.
- The levels of cash capital expenditure required to construct the mine and associated facilities and, subsequently, to replace obsolete or worn out equipment.
- Selection of the appropriate rate of discount to be applied in determining the present value of estimated future cash flows, having regard to the risks inherent in achieving such estimated cash flows.
In terms of their impact on value, certain factors are always the most significant:
- Tonnage and grade of the resource.
- Estimate of annual revenue.
- Selection of the discount rate.
Since production costs are determined by the number of tonnes of rock mined and processed, while revenues are determined by the number of pounds or ounces of metal produced, costs and revenues are related by the grade of the ore. Generally, however, profit is more sensitive to changes in revenue than it is to changes in cost, so grade and revenue are the cash flow factors which most affect the valuation.
The major metals, such as gold, copper, lead, zinc or nickel, can generally be assumed to be saleable since there are established markets of last resort and only the price has to be determined. With other commodities, the ability to sell the output from a new mine is far less certain unless a firm sales contract is already in place. In these cases, the appropriate rate of production cannot be selected without reference to the available demand and should be supported by a detailed market study. Ideally, a thorough, well-reasoned forecast of future supply, demand and price is an integral part of any valuation but it is particularly important for commodities for which pricing data are relatively opaque and consistent historical price series are lacking.
The Discount Rate
The discount rate used to reduce estimated future cash flows to present value is simply the rate of compound interest which the investor expects to receive on his cash investment. Generally, mineral property valuations are performed in terms of constant dollars, without consideration of future inflation.
It is well-accepted that a risky investment should command a higher rate of interest than a secure investment and it is recognized, too, that mining is a risky business. Therefore, it is common to include an increment for risk within the discount rate to allow for risks associated with the mineral resource, technical issues associated with mining and processing, estimated capital and operating costs, as well as political and environmental issues, taxation and commodity markets.
Operating mines should be valued at a lower discount rate, or required rate of return, than that applied to new projects since certain of the risks faced by new mines have been mitigated. Mineral properties which have been explored by drilling but have not yet reached the stage of resource assurance at which a definitive feasibility study can be undertaken, should be valued at a discount rate higher than that applied to later-stage projects. While there are generally accepted ranges of discount rates to be applied to properties at different stages of development and for different metals or commodities, the selection of the most appropriate discount rate to be applied to any specific property depends on the judgement and experience of the individual evaluator.
Real options analysis is not widely used in valuation but is recognized as a useful approach to analyzing uncertainty.
Any acquisition, merger or financing of mineral property rests on a determination of fair market value, often by an independent valuator. The approach, or approaches, methodology and assumptions should be clearly stated so that all relevant parameters are understood and can be accepted as the basis of a transaction.