## Valuation of gold stocks

In today’s post I want to look at valuation of gold stocks.

The last few days I’ve been trying to wrap my head around how to value gold stocks.

It’s not as easy as just valuing a normal manufacturing company with Debt to equity, Price to earnings or by Price to book value.

This is because of the value of the resources in the ground.

This makes it inevitable to normalize all the values calculated according to either production or reserves that the company has in the ground.

We will then get a number of ratios that are similar, but not identical, to the P/E ratio.

The first thing that we will look at is how to calculate the cash cost per ounce produced.

#### Calculating the cash cost per ounce.

The cash cost is calculated by subtracting Operational cash flow from Total revenue:

Cash cost = Total revenue – Operational cash flow

To get to grips with what this means we can visualize the subtraction like this:

Figure 1.Total cash cost is calculated by deducting Operational cash flow from Total revenue.

Which is equivalent to this identity which is used in a normal Income statement:

Figure 2. Net cash is calculated by deducting Cost of sales from Total revenue.

What we do in Figure 2 is that we simply subtract our Cost of sales from the Total revenue to arrive at Net cash.

Then to calculate the Cash cost per ounce produced we divide with the total production for the year:

Total cash cost per ounce = Total cash cost / Total production

The Total cash cost per ounce is then the number that we will use in the rest of our calculations.

The companies are doing the best they can to obfuscate this, but this is the true cost of producing an ounce of gold, silver or platinum.

#### Estimated operational cash flow

The next thing that we will look at is an estimate of how much money can come into the company through sales of the metal.

If we estimate that the company produces X ounces of metal in the year, the average cost of production is Y \$ per ounce and that the average price of the metal is Z \$ per ounce then the estimated operational cash flow of the company is:

Figure 3. Formula for calculating Estimated Operational Cash Flow (EOCF) in \$. FMP is the Forecast Metal Price in \$ per ounce, CPO is Cost Per Ounce Produced and EOP is the Estimated Ounces Produced in # of ounces.

Estimated operational cash flow (EOCF) = ( Y (\$ per ounce) – Z (\$ per ounce)) * X (ounces produced)

This number we will use in subsequent valuation calculations.

#### Price to Cash flow ratio

We can then use the Operational cash flow and calculate a Price to Cash flow ratio where a lower number indicates a cheaper stock.

If, for instance, the Price to Cash flow ratio is 5 then investors are paying \$5 for each additional dollar of Cash flow.

Typically this number ranges from 3 x to 30 x and the lower the number the cheaper the stock.

#### Market cap to Forecast production ratio

We can also use the the Market cap to figure out a valuation to forecast production ratio.

Here again the lower this number gets, the lower the stock is valued in the market.

Typically this number ranges from about \$1000 per ounce to \$25,000 per ounce.

The lower the Market cap is per ounce of forecast production the cheaper the stock.

#### Market cap to reserves ratio

What we look at here is the Valuation (or the Market cap) and divide with the total number of ounces that the company has in reserves.

This number typically ranges from \$100 to \$1000 depending on the location of the resource.

Again this is a valuation metric where a lower number is cheaper.

#### Price to Earnings ratio

This is the classic valuation ratio where the price of the stock is divided by the earnings.

For gold stocks this number is usually higher than for ordinary stocks and a number of 50 is not unusual.

The lower the number the cheaper the stock.

The question then of course becomes:

How can it be that the Gold stocks are so expensive that investors are gladly paying 50 times earnings to get it?

The reason is that investors are paying for the gold reserves and the gold production that the company have.

The equity valuation is just a part of the value.

#### Examples

So that you better understand what I mean when I talk about the value of different gold stocks, I will now give some examples:

The first is of a hypothetical gold mine ABC Gold Inc. that has the following Cash flow and Income statement:

Figure 4. Screenshot of Microsoft Excel showing how to calculate Total cash cost by subtracting Operating cash flow from Total revenue.

We then hit Enter and we get the result that we want in cell B6 (\$1360,000,000).

Then we continue to calculate the Cash cost per ounce by dividing B6 with B5:

Figure 5. Screenshot of Microsoft Excel showing how to calculate Cash cost per ounce by dividing Total cash cost by Total gold production.

Here again we hit Enter and we get the Cash cost per ounce in cell B7:

Figure 6. Screenshot of Microsoft Excel showing how to final values of Total cash cost in cell B6 and Cash cost per ounce in cell B7.

So what do we do with these numbers?

Well the first thing we can do is to calculate the Estimated operational cash flow at a given gold price:

Let’s say that we estimate that the average gold price will be \$1350 per ounce in 2017, the Total cash cost per ounce was \$817 in 2016 and that the company forecasts a production of 1,725,000 ounces in 2017, then the Estimated operational cash flow per ounce will be:

Figure 7. Screenshot of Microsoft Excel showing how to calculate an Estimated operational cash flow per ounce taking into account the Forecast average gold price (B9), the Forecast production (B10) and Estimated cash flow at \$1,350 per ounce.

We then see that the Estimated cash flow per ounce is \$533 and to get to the Estimated operational cash flow we multiply B12 with B10:

Figure 8. Screenshot of Microsoft Excel showing how to calculate an Estimated operational cash flow by multiplying the Estimated cash flow per ounce with the Forecast production (B10).

The result is of course as in Figure 9:

Figure 9. Screenshot of Microsoft Excel showing how to calculate an Estimated operational cash flow taking into account the Forecast average gold price (B9), the Forecast production (B10) and Estimated cash flow at \$1,350 per ounce.

#### Conclusion:

In today’s post we have been looking at the valuation of gold stocks as a function of their production and reserves in the ground.

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