Valuation Alert: Gold Miners Tumble Deep into the Bargain Basement
June 27, 2011
– Comments (11)
I have rigidly turned my back to employing price-to-earnings ratios as a tool for assessing share valuations in the mining sector over the years, and I believe I've had good reason. You see, the need to appropriately account for the value of a miner's underground reserves and resources causes P/E ratios within the sector to often appear quite elevated in relation to stocks from other sectors, resulting in what I have felt was an unnecessary psychological barrier that obscured value propositions for the less experienced resource investor. Of course, I pay very close attention to earnings and cash flow, but for valuation purposes I am far more interested in the longer-term perspective gleaned by comparing the value assigned to identified underground resources.
Newcomers to the resource sector may wish to imagine what might happen to their favorite industrial stock if all the materials required to produce their product were buried underground adjacent to the production line. If Ford Motor were to fortuitously discover 1 billion completed chassis of vintage Mustangs buried beneath its Detroit facility, and all the company had to do was to excavate them, drop in some engines, and pop on some tires, you can bet we'd see a major pop in the shares. Because that underground inventory would contribute to revenue over time, auto investors would also have to adjust their notions of an appropriate P/E ratio for the stock to account for the value of that inventory. Gold and silver royalty stocks form another peculiar subset of the group, and CAPS member speedybure recently offered some creative alternative valuation techniques for Silver Wheaton (NYSE: SLW ) and Sandstorm Gold.
These issues are not unique to gold and silver miners but are rather a shared peculiarity of all the extractive industries, including oil, coal, iron ore, etc. The effect can be partially overcome by using P/E ratios in the manner in which they are intended: strictly as a relative metric relevant only among a group comparable peers. In practice, however, I see far too many investors developing notions that anything above a certain P/E value is "expensive" regardless of sector, relative growth rates, etc. Even when properly utilized, however, P/E ratios remain a flawed metric for resource extraction stocks.
See when happens when we resuscitate the P/E metric for gold miners, by clicking to the article here.
Thank you in advance for your readership, your replies, and your recommendations.
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