Monday, October 17, 2011

Valuing mining stocks - long-term discounting

Mining stocks should be valued using a classic discounted cash flow analysis based on the life of the mine production times an expected price discounted by the expected cost of capital. 

The key variables that can further effect valuation include: include exchange rates, given many mining companies are outside the US and prices are often in dollars; capex which drain what is received by investors but also increase the potential supply; and dividends which are not reinvested in the commodity. The macro factors include the risk in the market and global growth which will translate into price variability. Of course, hedging is another variable in the mining equation, but if the mining company hedges, it is suggesting that they do not believe the price gain is permanent or that the volatility is high relative to what it expects.
This valuation of discounted cash flows is a long-term price risk not a short term inventory premium which is embedded in futures prices. Hence, futures will be  less correlated with mining stocks by being more sensitive to short-term dynamics. Temporary price moves will drive futures prices but will not have a large effect on mining stocks. Long-term or permanent price changes will have a strong effect on mining stocks but not on futures.

If mining stock lag futures price returns, it means that the market is discounting the current movement in prices. In the case of gold, mining stocks are suggesting that there will not be the same increase in price as measured with futures. The discounted cash flows do not translate to the large short-term gains or loses with futures. There is a reason to hold both mining and futures positions.

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