What is your opinion on this method for gold mining company valuation?
“Start with the number of ounces it has in the ground (a public number accessible to all of us), and simply divide that number into its market cap.
For example, Kinross Gold Corporation (KGC), as of this writing, has a market cap of $18.821 billion, with 62.4 million ounces of gold reserves. By dividing the number of ounces into the market cap, we get a figure of $301.62.
To this total we add the company’s cost to dig each ounce of gold out of the ground. In the case of Kinross, that’s $610. That makes the final figure $911.62 – the cost per ounce of gold you pay for buying Kinross stock. This represents a 49% discount on the current price of gold itself (based on the August 16 close of $1,787.10).”
Then you can compare these discounts for other gold miners and buy the most undervalued ones.
The described methodology is one of the ways that one can price a company based on its fundamental situation. To be precise, comparing share price to the amount of ounces that this company owns is one of the ways to look at the P/B (price-to-book-value) ratio. While the P/E (price-to-earnings) ratio is the most popular one, there are also other ratios that one can use and P/B is one of them.
There are several disadvantages to this methodology but the most important one is related to the mining sector. Quite simply, not all ounces are equal. Some ounces are "proven" – the company is certain that the ounces are there. Some ounces are "indicated" – the company is not sure the ounces really exist, but it’s highly probable. Finally, some ounces are merely "inferred," meaning that based on some drilling results, there might be more metal in the area – the company tries to guesstimate how many ounces there are and reports that as "inferred ounces."
You can think about it this way: you can have cash on hand (proven), or you can have signed a deal that should provide you with some cash in 12 months, or you can assume that when you complete your PhD studies you will likely get a better job and earn more money than you do now. As you see, these 3 piles of cash are very different and one should not mistake one with another. The same can be said of a company's gold reserves.
The cost of producing one gold ounce from an "inferred ounce" can differ not only between companies but also within a company, based on where these ounces are located and what type of mine is being used (is the mine an "open pit" mine or not?).
There should be no problem with the above-mentioned methodology as long as you are 100% sure that each of the analyzed companies uses exactly the same methodology when describing each ounce and that they all have the same accounting methods. You also need to be 100% sure that there are no accounting shenanigans because that could heavily distort ratios.
If all of the abovementioned requirements are fulfilled at the same time in all companies, then using the price-to-ounces ratio is ok. Unfortunately, this is not likely, so using price-to-ounces analysis is risky in our view.
Naturally, if numbers were calculated for similar companies with similar resources, operating in similar areas, and the price-to-ounces ratio for one company was several times bigger than the other one, then the outcome of the analysis would be meaningful. However, if companies are different and differences in results are minimal then this method is not very helpful when choosing stocks.
We believe that using the market approach is better than using a variation of the P/B ratio. Measuring how a company's shares respond to the price changes of underlying metals can also say a lot about a company's potential. It is also much less vulnerable to discrepancies between companies' accounting and geological assumptions (not to mention the possibility of manipulation). That's why our interactive gold and silver stock rankings use the market approach.
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