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Unlike industrial companies thathave revenues, many miningstocks belong to junior miners

that are still in various stages o explora-tion or development. This means not only

that they have no revenues or cash fows,

but also that investors need to use di er-

ent and innovative valuation methods inorder to evaluate them.

Junior mining involves companies

engaged in the earlier and/or smallerscale stages o exploration, development

and production. They are inherently more

speculative and more risky than othertypes o investments. However, the oldnance rule that more risk equals morepotential return holds true.

The process o valuation is doneor the purpose o determining what anasset is inherently worth, which will likelydier rom the market value o the asset.This di erence, between inherent andmarket value, is where opportunities lie.

The market value is what the asset is cur-rently selling or.

Once the inherent (more com-monly known as intrinsic) value o anasset is determined, the investmentdecision is then a relatively easy one.

i:

Intrinsic Value is bigger than MarketValue, then BUY the stock;

Intrinsic Value is the same as MarketValue, then HOLD the stock;

Intrinsic Value is less than MarketValue, then SELL the stock.

Intuitively, you can make the sameanalogy with any purchase decision. Iyou believe something is worth more than

it is currently selling or, you buy it. I it isselling at a price that is more than the

value to you, you do not buy it.In order to value an asset, one

needs to build a valuation model, to beused or determining intrinsic value. AtFundamental Research Corp, we usethree valuation methods: Discount CashFlow, Real Options and ComparablesValuation (depending on the stage o themining company).

Inputs

The rst part o building a model is to

determine the inputs. This is where thereal analysis takes place. Analyzing theactors that lead to which inputs are used

must be done careully, otherwise you get

garbage in/garbage out.Various actors o a junior mining

stock are analyzed, rom the geologicalnature o the projects to the political risks

involved in the world in which the company

is operating.

The ollowing ve main inputs arederived or valuing resource companies:

1. Resource Estimate.Resource estimates can be pri-

marily categorized as 43-101 compli-ant estimates in Canada (calculated byindependent consultants) or historicestimates which are not 43-101 com-pliant. In our valuation models, we use

100% o 43-101 compliant measured andindicated resource estimates. However,or conservatism, we typically discount43-101 compliant inerred resourcesand historic resources by 50%. In somecases, we also use resource estimatescalculated by our in-house geologists,based on historical drilling and explora-tion conducted to date.

2. Recovery Rates.

For recovery rates, we use inorma-tion rom metallurgical studies conducted

to date, as well as recovery rates o com-parable deposits.

3.Commodity Price

Assumptions.

These are determined based on our

outlook on the commodities o interest. It

is important to note that, or projects that

are not currently producing and are notintended to be put into production in thenext three years, a long-term outlook oncommodity prices is more important than

Determining the Real Value of JuniorMining Companiesby Brian Tang

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MINING.com March - April 2010

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current prices. We cannot totally discount

the benets o current commodity prices

on projects that are not in production be-

cause, i current commodity prices arehigh, a company targeting that commod-

ity will receive more ocus rom investors.

We also study the impact o commodityprices on share prices, based on histor-ical data. It gives us an idea as to howshare prices could react to changes incommodity prices in the uture.

4. Operating and Capital Costs.

These costs are determined dependingon whether the proposed mine is anunderground or an open pit mine, thetype o metallurgy, geographical location

o operations, etc. Typically, we use com-

pany specic inormation and inormation

rom comparable deposits to determineour cost estimates.

5.Discount Rates.

These are set based on the type oproject, stage and geographical location.

For example, a project in the DRC, which

is in the same stage and targets a similardeposit as a project in the mining riendly

province o, Manitoba, Canada, will havea higher discount rate because o the as-

sociated political and geographical risksassociated with the country. Discountrates are inversely related to air value.

The higher the discount rate, the lower aprojects value.

Valuation Models

Once the above-mentioned ve inputsare determined, we input them in ourvaluation models.

1. Discount Cash Flow Valuation.

It is only appropriate or compan-ies in production, very near production,or with enough inormation that we can

reasonably estimate cash fows romproduction. The theory behind discountcash fow is that the value o every assetis simply the present value o the cashfows this asset produces over its lietime.

It should be noted that DCF valuation

models are highly sensitive to commodity

price, cost and discount rate assump-tions. It is essential or investors to de-termine the sensitivity o their valuationto each o these inputs. Investors shouldknow what the valuation will be in a worst

case scenario to get an idea o the down-

side potential and, in the best case scen-

ario, to know the upside potential.

2. Real Options Valuation.

This is a proprietary valuation model

that we use at Fundamental ResearchCorp based on the Black-Scholes optionpricing model. This model is very useul in

valuing early stage projects by essentially

treating the resource in the ground asan option. Management has the optionto pursue a project or abandon it basedon new inormation. Real options valua-tion has allowed us to put a quantitativevalue on assets that would otherwise bevirtually impossible to value. As a quickanalogy, a call option becomes in-the-money when the stock price rises abovethe strike price. Similarly, our real options

model becomes in-the-money when theexpected cash fows rom a mining pro-ject rise above the cost to put the project

into production.

3. Relative Valuation.

Comparables are selected based on

the type o project, stage, geographicallocation and market capitalization. Acompanys air value is determined based

on applying the average ratio, most oten

average enterprise value (EV) to resource,

o its peers to the company being valued.

We also did a comparables valuation onROI using 2.6 cents per lbs Cu and came

up with a valuation o $0.46.Ater using one or all o the three

methods described above, we look atthe air value determined by each method

and use that as a basis or coming upwith a nal air value. In the case o ROI,our analysts decided on a air value o$1.69. At this point you may notice alarge discrepancy in the air value de-rived rom the three methods. While adiscussion regarding the reason or this

is beyond the scope o this article, someo the reasons that the methods give di-erent air values are:

comparables depend on currentmarket prices, so, i the marketis undervalued, all assets will beundervalued;

as or DCF and Real Options, onereason or the dierence is relatedto the time assumptions used;

options become more valuable astheir time to expiry increases.

While we are doing our analysis andvaluation, we are always looking out orthe ollowing red fags:

companies with less than threemonths o cash on hand and thatare having problems raising capital;

management team with little experi-ence in the industry and in raisingcapital;

higher than industry average man-agement compensation and optionpay outs;

a board which is not trulyindependent;

non-arms length transactions; companies that do not regu-

larly publish results o their drillingprograms;

projects located in politically un-stable regions or which could pot-entially have a signicant negativeimpact on the environment.

In addition, the ollowing are somecommon mistakes that we believe invest-

ors make in their investment decisions:

investors have a tendency to investin early stage projects (ar rom

production) when commodity pricesare high, even though the long-termoutlook on commodity prices is notavourable. Although this strategymight lead to short-term gains, it isless likely that such investments willbe good in the long-term;

companies tend to over ampliy thesignicance o their drilling results.It is very important or investors tolook at the true widths and gradeso all the recently published resultsbeore making an investment

decision; a company might have good resour-

ces, but i the value o the resourceis lower than the total operating andcapital costs over the mine lie, itmight not be a good investment;

investing without proper analysis orisks.

Although, timing the market is verydicult, i not impossible, investors cankeep in mind the ollowing cycle o a

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mining project in determining whether totake a position. During discovery andexploration, there is usually an increase in

stock price as investors speculate, based

on preliminary drilling or other samplingresults, whether or not the company has

ound anything. As the company denesresources and releases urther results,institutional investors usually becomeinterested in the stock. At these stages,the stock tends to increase.

Once a decision is made to pro-ceed with easibility, the stock pricemay decline as investors worry that aeasibility report may deem the projectuneconomic. I a decision is made to gointo production, the stock will still remainrelatively fat, as investors are uncertainwhether a company can secure nan-cing and permits. Once nancing andpermits are in place, the stock may startto increase again, although at a slowerpace, due to uncertainty regarding costover-runs and other surprises.

As the mine starts production, thestock should then increase at a asterrate. The above discussion is a simpli-cation as the stock is also infuencedby general market risk and commodityprice risk.

Analyz ing junior mining compan-ies is a serious task and more similarto art than science. However, when

equipped with the right tools, ana-lysts should be able to make an in-ormed decision considering the ap-propriate risks and expected return.

* Brian Tang is the President of

Fundamental Research Corp

Links and References

An Intro. to Evaluation o...

An Introduction to Mining... Feasibility Studies Fundamental Research Corp Intrinsic Value Market Value - Denition Mining Stocks Guide National Instrument 43-101 The Mining Stocks Report

Click here or ull list o links:http://go.mining.com/mar10-a2

Many mining stocks belong to junior miners that are still in various stages of exploration ordevelopment.

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