Piotr Saluga, Ph.D.

Polish Academy of Sciences

Mineral & Energy Economy Research Institute of Cracow, Poland

 

 

Methods of Mineral Properties Valuation

 

Key values: minerals, mineral properties, valuation

 

Abstract

Efficient use of national mineral resources is widely connected both with improvement of the national legislation system and adequate introduction of economic mechanics. One can expect that these tasks will be the focus of attention of state administration in coming years. The important function at securing all rights of all resources users falls to valuation issue. The paper provides a brief overview of methods used for mineral asset valuation and implies use of specific method, depending on the property’s development stage.

 

1. Introduction

 

Dimensions of the world are less or more finited. Goods and resources it offers us are limited by its volume and accessibility; therefore they have their own value, depending on their quantity, quality and rarity.

            People buy and sell goods. Pricing is then a very important task in economy. After Webster’s Encyclopedic Unabridged Dictionary, valuation is:

(1) the act of estimating or setting the value of something; appraisal,

(2) an estimated value or worth,

(3) the awareness or acknowledgement of the quality, nature, excellence, or the like, of something.

It is clear that a seller is going to sell a good at the highest price whilst a buyer wants pay the least possible money for it. The price they agree is called ‘fair market value’, FMV, which after definition is ‘the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of relevant facts’ [Appraisal Foundation 2006]. This definition requires that following requirements must be met:

(1) both seller and buyer must be willing and no under compulsion,

(2) the transaction must be arm’s length,

(3) both seller and buyer should be informed or have reasonable knowledge of the associated facts.

            These ideal conditions don’t occur in real world, that’s why determining of true fair market value is very difficult, if not impossible.

                       

2. Goals of mineral properties valuation

 

Mineral assets are very difficult to value. It is because of specific features of mining investments, mainly connected with deposit i.e.:

(1) rarity of occurring,

(2) unique location,

(3) depletion problem,

(4) uncertainty and uniquity of deposit’s volume, structure, and geologic characteristics.

            Other characteristics of mineral assets are:

(5) exceptionally long pre-production (investment) period,

(6) long production (mining) period,

(7) diversified production conditions,

(8) capital intensivity,

(9) inflexibility of production process,

(10) unpredictability of mineral prices, connected with their cyclical character.

Mineral assets are valued for many reasons. The main purposes of mineral asset valuation are:

(1) exploration lease / concession bids,

(2) initial public offerings,

(3) asset buying / selling prices, asset disposals,

(4) merger and acquisition transactions,

(5) stock market transactions,

(6) expropriation,

(7) litigation settlements,

(8) financial collateral,

(9) insurance claims,

(10) assessment of bank security,

(11) taxation purposes,

(12) securities reporting,

(13) accounting purposes, book value adjustments.

            Because sophisticated pricing task and its importance for the mineral market and mining companies shareholders, the valuation of mineral assets is conducted by experienced, well-educated, independent experts, members of professional, self-governing institutions. Valuators can choose between three valuation approaches, including several more or less sophisticated methods.

 

3. Valuation approaches & methods

                                              

The mineral asset valuators use three methodical approaches:

(1) the cost approach,

(2) the market approach,

(3) the income approach (including option pricing approach).

            It is commonly accepted that independent valuator can choose among above mentioned approaches but must use at least two methods

 

3.1. The cost approach

 

The cost approach is a market value indicator that comes from real estate and based on the principle of contribution to value. This approach is focused on what was spent on the property plus or minus a discount or premium as the case may be e.g. replacement cost less accrued depreciation.

            The basic methods of the approach are [Spence 2000]:

(1) appraised value method (meaningful past exploration costs, plus warranted future costs),

(2) historical cost method (cost less any outstanding obligations and/or – in Anglo-Saxon countries – depletion.

There are some execution problems with the cost approach. The most meaningful among them are listed below [Hammond 2000]:

(1) depreciated book values vs. true replacement costs,

(2) lack of / ignoring statistics on mineral discoveries, reserves, etc.,

(3) ignoring the geographic / geologic location of the asset,

(4) ignoring importance of ‘geological expertise’ in prospect development.

 

3.2. The market approach

 

The second approach used in mineral asset valuations is the market approach. This approach presents comparable analysis of current (or past) selling prices of comparable objects with essential improvements considering most important differences between objects. The approach places emphasis on amount, that purchaser is willing to pay for the object, so that it focuses directly on sales data. Because it is based primarily on the principle of substitution it’s often called the sales comparison method.

The basic sources for valuation in the sales comparison method are [Roberts 2000]:

(1) value paid in a direct asset transaction,

(2) value paid in a corporate acquisition transaction,

(3) value implied in a merger transaction,

(4) current trading value of a company.

As quotes Roberts [2000] the valuators have to compare the objects in many fields:

(1) commodity or product,

(2) date of valuation data,

(3) location,

(4) reserve size,

(5) deposit type, mining method,

(6) process method,

(7) cost of production, grade, margin,

(8) capital cost, infrastructure.

            The approach sales comparison method has some essential shortcomings Hammond 2000]. First and very difficult to overcome is an insufficient number of comparable transactions. The data is often inaccessible or classified. Another problem is that selected transactions are not enough comparable in various fields such as geological conditions, location, scale of operations, mining method, market proximity, transaction term, etc. Value adjustments are often ignored or only partially performed.

 

3.3. The income approach

 

The third widely used method is the income approach. The approach is based on the principle of contribution to value [Ellis 2000] and focuses on the cash flow profits generated from the object of valuation. It provides a means of relating the magnitude of expected future cash profits to the magnitude of the initial cash investment required to purchase an asset or to develop it for commercial production.

 

DCF Analysis

 

The most important method in the income approach is discounted cash flow analysis (DCF). The value measure of DCF analysis is net present value (NPV). NPV is the sum of the present values of all yearly cash flows less the initial investment; NPV reflects the value an object appears to provide given a discount rate and a set of cash flow assumptions,

            There are several execution problems with the income approach. The most important can be enumerated as follow [Roberts 2000]:

(1) incorporating financing considerations in fair market value (FMV) estimations,

(2) ignoring tax liabilities and shields,

(3) arbitrary discount rate assumptions,

(4) applying post-tax discount rates to pre-tax cash flows,

(5) applying current money (escalated) discount rates to constant money (unescalated) cash flows,

(6) usually very poor treatment of risk.

 

The real option valuation

 

Fig. 1. Options in Mineral Industry
The second method within the income approach is the real option valuation method (ROV). This method is of growing importance today. Unlike the DCF analysis the ROV method prices managerial flexibility, i.e. it means that a manager during realization of mining project has always a possibility to conduct an appropriate action depending on market situation. This possibility of activity has monetary value. The managerial flexibility’s value depends on profitability of the project – e.g. it’s substantial for marginal projects and almost unimportant for high profitable projects. Figure 1 presents options met in mineral industry, depending on time i.e. development stage.

 

 

 

3.4. Hierarchy of Valuation Methods

Fig. 2. Hierarchy of Mineral Asset Valuation Methods [Hammond 2000]

Figure 2 summaries all valuation methods used for pricing mineral assets. A horizontal axis on the diagram ranks methods regarding size and importance of decision or appraisal, whilst the vertical takes into consideration complexity. Methods are then classified with growing level of analytical sophistication, information received and complexity.

 

 

Among simple valuation methods can be numbered methods like:

(1) ‘WAGs’,

(2) book value,

(3) replacement cost,

(4) „simple” comparable sales,

(5) payback,

(6) simple multiples (e.g. sales revenue, operating income, cash flow, production volume, production capacity, units of reserve).

More sophisticated valuation methods include:

(1) net present value, NPV (discounted cash flow, DCF),

(2) adjusted present value,

(3) adjusted market capitalization comparable sales,

(4) Monte Carlo simulation,

(5) decision analysis.

To advanced valuation methods belong:

(1) real option analysis,

(2) ROV (DCF, simulation, option theory and decision trees combined).

            Selecting of method depends on development stage of the property, project scale, quantity and quality of information gained, risk involved, ‘know-how’ and experience of valuator. The crucial factor is often development scale.

 

 

3.5. Valuation methods at various stages of property development

 

Figure 3 presents dominant methods of pricing used at different stages of development of mineral project. At early stage exploration the preferable methods are the appraised value method within the cost approach and the sales comparison method within the market approach. This is mainly because of lack of information.

 

Fig. 3. Dominant Methods of Valuation at Different Stages of Mineral Property Development

 

DCF analysis of the income approach and the sales comparison method of the market approach are most popular for valuing properties at pre-development and development stages and for operating mines as well. Selection of method/approach depends on the data available. For marginal properties, including deposits with NPV lesser than initial investment cost the preferable method is real option valuation.

            The method most commonly used at the stage of mine closed is salvage value and other methods, depending on information gathered and requirements needed.

 

4. Valuation Standards

 

In order to make mineral valuations fair, clear and reliable some countries have introduced regulations (so called ‘codes’) that summarize and order pricing rules and give guidelines of mineral projects valuations as well. Some of them have been executed – some have been still at working or draft stages. These standards are listed as follow:

(1) VALMIN Code, 1995, Australia

           (Australasian Institute of Mining and Metallurgy, AusIMM)

(2) CIMVal Code, 2003, Canada

           (Canadian Institute of Mining, Metallurgy and Petroleum, CIM)

(3) US Minval Code, 2002, USA – draft,

           (Mining & Metallurgical Society of America, MMSA)

(4) SAMVAL Code, 2000, South Africa – draft,

           (South African Institute of Mining and Metallurgy, SAIMM)

(5) IVS (International Valuation Standards) – at working stage

(Extractive Industries Task Force of International Valuation Standards Committee, IVSC)  

The VALMIN (Code for the Technical Assessment and Valuation of Mineral and Petroleum Assets and Securities for Independent Expert Reports) is the oldest (first draft – 1995) and most famous standard of mineral asset valuation. The Code was worked out by a few Australian organizations, leading by Australasian Institute of Mining and Metallurgy (AusIMM). The VALMIN Code has received wide recognition among many valuation specialists, consultants and analysts from many countries [Lawrence 2000, Ellis 2004].

The VALMIN Code was served as pattern for analogous Canadian standard called CIMVal Code (Standards and Guidelines for Valuation of Mineral Properties), which took effect in 2003 with applause of Canadian mining industry circles. American US Minval Code, South African SAMVAL Code and international IVS, drafted by Extractive Industries Task Force of International Valuation Standards Committee (IVSC) are still at a working stage [Ellis et al. 1999, Heffernan 2004].

 

5. Conclusions

 

Valuation of mining properties is unquestionable very important task. This is because of specifics and scale of mining ventures. The work can be done by qualified valuators only.

            There are three basic approaches to valuation: cost, income and market approach that include many pricing methods. The valuation methods vary from simple to advanced, depending on data gathered and a stage of property development – at various stages of development one should use appropriate methods.

Valuation rules regulate national valuation standards. The oldest and most known standard is Australian VALMIN Code, which was introduced in Australia mid 1990’s. The VALMIN was a basis for second working standard – Canadian CIMVal. Because of need of drawing up an international standard of mineral asset valuation, since a couple of years the specialists of valuation have been working on it. The project called IVS (International Valuation Standards) is going to be finished in coming years.

 

 

References

 

Appraisal Foundation: The Uniform Standards of Professional Appraisal Practice. Appraisal Standard Board of the Appraisal Foundation. Washington, DC, 2006.

Ellis T.R. : The US Mineral Property Valuation Patchwork of Regulations and Standards. CIM. http://www.cim.org/mes/pdf/VALDAYTrevorEllis.pdf, 2000.

Ellis T.R.: International Perspective on U.S. Minerals Appraisal Standard Development. Mining Engineering. Technical Papers. 2004.

Ellis T.R., Abbott D.M., Sandri H.J.: Trends in the Regulation of Mineral Deposit Valuation. SME Annual Meeting 1999. Denver, CO. USA. Prep. 99-29.

Hammond D.R.: Current Issues in the Valuation of International Mining Assets. Presentation to the International Mining Professionals Society. Hammond International Group. Denver, Colorado. December 13, 2000.

Heffernan V.: Mineral Property Valuation – International Movement to Standardize Property Valuation Gathers Momentum. 2004.

Lawrence M.J.: The AusIMM's VALMIN Code (1998) – Now an International Guide to Project Assessment and Valuation Best Practice. The Codes Forum Proceedings. Sydney, Australia. p. 1-6. 2000.

Roberts C.: The Valuation of Advanced Mining Projects and Operating Mines: Market Comparable Approaches. Mineral Economics Society. Special Session on Valuation of Mineral Properties Mining Millennium 2000 – March 8, 2000. Toronto, Ontario. http://www.cim.org/mes/pdf/VALDAYCraigRoberts.pdf, 2000.

Spence K.: An Overview of Valuation Practices & the Development of a Canadian Code for the Valuation of Mineral Properties. Special Session on Valuation of Mineral Properties Mining Millennium 2000 – March 8, 2000. Toronto, Ontario. http://www.cim.org/mes/pdf/VALDAYKeithSpence.pdf, 2000.