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XMFSinchiruna (26.48)

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.

11 Comments – Post Your Own

#1) On June 27, 2011 at 10:52 AM, XMFSinchiruna (26.48) wrote:

In other news:

U.S. House, Obama Admin. debate gold reserves transparency

PIMCO sees commodity-driven inflation for 3-5 years

Situation for miners in Peru deteriorating

Beautiful high-grade intercepts at new discovery; Cow Mountain

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#2) On June 27, 2011 at 11:21 AM, Frankydontfailme (28.85) wrote:

Thanks Sinch

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#3) On June 27, 2011 at 11:24 AM, kdakota630 (28.93) wrote:

I was just going to ask you if you knew about Bear Creek, but it appears you do.

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#4) On June 27, 2011 at 11:31 AM, Frankydontfailme (28.85) wrote:

Any update/thoughts on the regime change of Peru affecting SLW? Obviously you're long term bullish. Do you anticipate short term weakness?

What is the worst case scenario? I think it could drop to 29 or lower with deflation concerns and unsettled geopolitical developments (here I'd definitely buy), but I'd appreciate your opinion. 

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#5) On June 27, 2011 at 12:07 PM, XMFSinchiruna (26.48) wrote:


Glencore, which operates the Yualiyacu mine, SLW's sole major exposure to operations in Peru (those 2 Barrick streams are near-term bridges to Pascua Lama production), just purchased a copper project in Peru for $475m. I have no concerns regarding SLW in relation to Peruvian political dynamics.

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#6) On June 27, 2011 at 12:23 PM, Jbay76 (< 20) wrote:

Not to sidetrack the discussion, but I wonder if the Peruvian Government is dealing with each miner one at a time?  I checked Tina Resources website and found nothing on the issue, happily so as their entire operation is focused in Peru.

Sinch, are you familiar with how governments handle this sort of biz., is it one company at a time?


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#7) On June 27, 2011 at 1:44 PM, XMFSinchiruna (26.48) wrote:


Undeveloped assets in Peru require an elevated risk assessment at present. The full ramifications of Garcia's presidency are not yet known, though in the case of established major miners like Southern Copper I believe the market has already priced in elevated risk of higher effective tax rates.

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#8) On June 27, 2011 at 2:13 PM, Frankydontfailme (28.85) wrote:

OK thanks again. I see what you mean. I worry about the irrationality of the market but clearly you are thinking long term, which makes it greatly undervalued.

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#9) On June 27, 2011 at 2:57 PM, Jbay76 (< 20) wrote:

Thanks Chris!

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#10) On June 28, 2011 at 7:16 AM, skypilot2005 (< 20) wrote:

Here are links to Sandstorm’s management team:  Both Gold and Metals & Energy

This was an important factor in my deciding to start accumulating some shares earlier this year.

Sky Pilot

Official Web Link Assistant to Sinch

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#11) On July 01, 2011 at 1:29 PM, walt373 (99.86) wrote:

P/E ratios are only useful if the current earnings give a good approximation for the long-term earning power of a company, which generally is not the case for resource companies because of cyclicality and because commodity prices are anything but stable, so I agree with you that P/E ratios are generally less useful for resource companies. But I hope you don't mind me nitpicking your example.

In your Ford example, the shares would definitely pop if Ford discovered 1 billion completed chassises, but not because of an expanding P/E ratio. In this case, what would happen is that the cost of goods would fall substantially in the following year and the savings would drop to the bottom line, producing a huge one-time surge in earnings.

However, the following years would not see a similarly huge growth in earnings. Earnings would maintain their elevated level but you will not see another big increase YOY. So this year's P/E would be useless but next year's P/E would be relevant. Contrary to when you say "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," the value of the inventory will be reflected in a higher gross margin and thus higher earnings. If you adjust the P/E upward after using the higher earnings produced by cheap inventory, you would end up double-counting.

However, the amount of chassises in the ground matter too. You'd have to adjust the P/E downward depending on how many chassises you have buried. Because once you run out of chassises you can dig up, your cost of good sold will go back up and your earnings will fall to original levels. As a hypothetical, if you have two companies with stable earnings, and one is dependent on stuff it has buried in the ground while the other can sell goods at a certain cost indefinitely, the one dependent on a finite resource is clearly worth less.

There are of course reasons that you'd want to adjust the P/E ratio upwards for a resource company that you wouldn't do in your Ford example, like rapidly rising commodity price - car prices aren't nearly that cyclical. In the end that just boils down to your opinion on commodity prices. Or if some companies are not operating at full capacity, you'd want to adjust the potential earnings in your P/E, etc.

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