Gold mining stocks offer leverage to gold as their profits go up more than gold bullion itself. Because of its leverage mining companies offer more upside potential than physical gold. However, picking the right stocks makes all the difference since mining shares are inherently more risky.
Gold mining stocks have different characteristics from general equities, and traditional measures such as P/E ratios don’t do well in assessing the true value of the company. Other factors such as company cost, production rates and development trends are more important. Bud Conrad at Casey Research created a model of how to analyze gold mining stocks based on eight different factors:
- Proven and Probable Reserves – Total amount the mine is expected to produce.
- Cash Cost Per Ounce – The cost per ounce the company expects to pay for labor, equipment, etc. to take the reserves out of the ground and to the market place.
- Mine Asset Value – The difference of the price of gold today and the production cost per ounce multiplied by total reserves.
- Debt – Total debt of the mine. Mines are very expensive and most borrow to start production.
- Hedge Liability – An obligation the mine has to deliver gold at a future price that is below the market price.
- Mine Asset Value – The mine asset value minus debt and minus hedge liability.
- Market Cap – The total amount of shares outstanding multiplied by its share price.
- Valuation Ratio – The market cap divided by net asset value.
The purpose of Bud Conrad’s model is to compare the gold reserves in the ground to the stock price to see whether the price is low enough to be attractive. The table below compares the value of different gold mining companies. The far right column shows the valuation ratio. A ratio of 1.0 indicates that a company’s stock may be expensive compared to its assets and a value of closer to zero indicates a bargain.
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The valuation provides a basic guide line of value but it will change as conditions change. The valuation of certain stocks will change more or less from company to company depending on the change in price of gold and the company stock.
In addition, before investing in gold mining shares the following five factors should be considered.
- Cash flow – Does the company have strong cash flow and cash reserves?
- Income generation – Does the company have good income from producing gold out of the earth and what is the cash cost per ounce?
- The quantity of proven or measured reserves in the ground – How much of the gold in the ground has a 90% chance of recovery?
- Little or no hedging – How much hedging is the company involved in? Some companies hedge to raise capital but this often proven to be a bad long term strategy.
- Low debt levels – Nothing gets a company in more trouble than too much debt.