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  • Mining Valuation: Three Steps Beyond A Static DCF Model: Feature

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    The document discusses three ways to improve upon the traditional discounted cash flow (DCF) model for valuing mining projects: 1) Using dynamic modeling to account for how uncertainty in variables like metal prices changes over time, rather than static single-value estimates. 2) Accounting for flexibility in operating policies and financing/tax structures in response to changing conditions. 3) Applying market-based risk adjustment methods from finance, rather than the DCF model's aggregate risk adjustment, to better reflect each project's unique risk profile. Leading mining companies are exploring these enhancements to improve valuation and risk management.

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    Minival

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    The document discusses three ways to improve upon the traditional discounted cash flow (DCF) model for valuing mining projects: 1) Using dynamic modeling to account for how uncertainty in variables like metal prices changes over time, rather than static single-value estimates. 2) Accounting for flexibility in operating policies and financing/tax structures in response to changing conditions. 3) Applying market-based risk adjustment methods from finance, rather than the DCF model's aggregate risk adjustment, to better reflect each project's unique risk profile. Leading mining companies are exploring these enhancements to improve valuation and risk management.

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    61 views4 pages

    Mining Valuation: Three Steps Beyond A Static DCF Model: Feature

    Uploaded by

    2fercepol
    The document discusses three ways to improve upon the traditional discounted cash flow (DCF) model for valuing mining projects: 1) Using dynamic modeling to account for how uncertainty in variables like metal prices changes over time, rather than static single-value estimates. 2) Accounting for flexibility in operating policies and financing/tax structures in response to changing conditions. 3) Applying market-based risk adjustment methods from finance, rather than the DCF model's aggregate risk adjustment, to better reflect each project's unique risk profile. Leading mining companies are exploring these enhancements to improve valuation and risk management.

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    15/3/2017 MiningValuation:ThreestepsbeyondastaticDCFmodelCanadianMiningJournalCanadianMiningJournal

    Feature

    MiningValuation:ThreestepsbeyondastaticDCFmodel
    Theprimaryvaluationmethodologyfordevelopmentpropertiesandproducingminesisdiscountedcashflow("DCF").Theunderlyingvaluation
    premiseisthatvaluereflectsthecurrentneteconomicbenefitofthenetcashflowsthatareexpected...

    Theprimaryvaluationmethodologyfordevelopmentpropertiesandproducingminesisdiscountedcashflow(DCF).Theunderlyingvaluationpremiseisthatvalue
    reflectsthecurrentneteconomicbenefitofthenetcashflowsthatareexpectedtobegeneratedoverthelifeoftheproject.Calculatingthisbenefitinvolves
    estimatingexpectedaftertaxcashflowsandconvertingthesecashflowsintoapresentvalueornetassetvalue(NAV)throughaprocesscalleddiscounting.The
    discountingprocessincorporatesadiscountfactortoprovidearateofinvestmentreturnthataccountsforboththetimevalueofmoneyandriskfactors.

    DCFNAVcalculationshavemanyusesintheminingindustry,includingjustifyingprojectdesignchoicesorinvestmentdecisions,supportingNI43101resource
    declarationsandprovidingvaluemeasurementsforaccountingtests.WhiletheDCFmethodiswidelyaccepted,itissubjecttolimitationsandisattimesunreliable.
    AgoldsectorexampleisthecalculationofagoldprojectsNAVbyvaluatorsoranalystswhothenmultiplytheresultbyafactorof(say)1.8inordertoreconcilethe
    DCFNAVwithmarketvaluations.ThisdiscrepancyisusuallyattributedtotheDCFmethodnotrecognizingoptionalityorexplorationpotentialoftheproject.

    ValuatorsattheforefrontofminevaluationareseekingtoimproveDCFcalculationsthroughthreesignificantenhancements:thedynamicmodellingofuncertainty,
    therecognitionofthecashfloweffectsandcontingentpayoffsandtheuseofmarketbasedriskdiscountingmethodssuchasrealoptions.

    Dynamicmodellingofuncertainty

    StandardDCFmodelsarestatictheyincorporateasinglenetcashflowstreamwithmostlikelyorexpectedvaluesofprojectandbusinessvariablessuchasmetal
    grade.AnalystsrecognizethatthesevariablesareuncertainandmayassesshowuncertaintyimpactsNAVwithasensitivityanalysiswherevariablessuchasmetal
    pricearediscretelyvariedoverarange.MoreinvolveduncertaintyanalysismayincludeMonteCarlosimulation,inwhichasetprobabilitydistributiondescribes
    possiblechangesinaspecificvariableduringtheproject.

    http://www.canadianminingjournal.com/features/miningvaluationthreestepsbeyondastaticdcfmodel/ 1/4
    15/3/2017 MiningValuation:ThreestepsbeyondastaticDCFmodelCanadianMiningJournalCanadianMiningJournal

    Neitheroftheseanalytictechniquesconsidershowforecastsareupdatedanduncertaintyisresolvedduringaproject.IntroducingstochasticprocessesintoMonte
    Carlosimulationcanprovidearicherdescriptionofthedynamicsofuncertaintyanditseffectoncashflow.Forexample,alognormalstochasticprocesscanbeused
    tomodelreversioninbasemetalprices.Reversionisthetendencyofavariablesuchasmetalpricetorevertovertimetoalongtermequilibriumlevelandmayact
    torestrainlongtermcashflowuncertainty.Thesemodelscanbeextendedtoreflectothercharacteristicssuchasuncertaintyinlongtermequilibriumpricelevels
    andthestructureofforwardcurves.

    FlexibilityandContingentPayoffs

    AstaticDCFmodelreliesonacashflowscenariobuiltonasingledevelopment/productionpolicy,combinedwithpredeterminedfinancingandtaxationpayouts.
    Unfortunately,thisscenariomayprovideaflawedestimateofcashflow,sinceoperatingpolicymaybealteredandthestructureoffinancingandtaxationpayoffs
    transformedinresponsetochangesintheprojectandbusinessenvironment.ThislimitationofstaticDCFisparticularlyproblematicwhenattemptingtoestimatethe
    valueofsubeconomicresourcesatagoldorcoppergoldmine,theeconomicimpactofwindfalltaxes,orthetruecostofafinancingarrangementwithembedded
    commodityderivatives.

    ItisstandardindustrypracticetooffsetthisDCFdefectbybuildingaseriesofmodelsfordifferentdesignsandprojectenvironments.However,thisapproachresults
    inascatteringofNAVsthatoftenprovidelittleinsightintohowflexibilityandcontingentpayoffsinteractwithuncertaintytoaffectprojectNAV.

    Marketbasedvaluationmethods

    ThestructureofriskdiscountinginastandardDCFNAVcalculationimpliesanuncertaintyprofileinwhichnetcashflowuncertaintygrowsovertimeinawell
    behavedmanner.However,formostprojects,netcashflowuncertaintyisnotwellbehavedasitchangesannuallyinanerraticmannerduringtheprojectdueto
    factorssuchaschangesinmetalpriceandgradesandtheexhaustionoftaxshields.Theinconsistencybetweenaprojectsactualriskprofileandtheprofileimplied
    bytheDCFriskdiscountingformulaisparticularlyproblematicwhenvaluinglonglifebasemetalprojectswherelargeupfrontcapitalexpendituresarerequiredbefore
    cashflowsaregeneratedoverperiodsofmorethan30years.

    Financehasdevelopedmarketbasedmethodssuchasoptionpricingtovaluefinancialassetswhichhavedynamicriskcharacteristics.Thesemethods,when
    adaptedfortheminingindustry,usethesameinformationandhaveasimilarapproachtobuildingacashflowmodelasthestandardDCFmethod.However,the
    DCFandmarketbasedNAVmethodsaredifferentiatedbyhowtheyapplyariskadjustment.WhereastheDCFapproachappliesanaggregateriskadjustmenttothe
    netcashflow,marketbasedmethodsapplyatailoredriskadjustmenttoindividualuncertaintysources(e.g.copperprice)basedontheirsystemicriskcomponent
    beforebuildingupariskadjustednetcashflow.

    Notjusttheory

    http://www.canadianminingjournal.com/features/miningvaluationthreestepsbeyondastaticdcfmodel/ 2/4
    15/3/2017 MiningValuation:ThreestepsbeyondastaticDCFmodelCanadianMiningJournalCanadianMiningJournal

    ThediscussioninthisarticlebyTheErnst&YoungTeammayappeartobemoretheoreticalthanpractical.However,theauthorshaveobservedthatmanyleading
    miningcompaniesareactivelyundertakinginternalinvestigationsofthethreeenhancementstoimprovetheirvaluationandriskmanagementprocesses.Whilemost
    oftheworkbeingperformediscurrentlyforinternaluse,publiclydisclosedexamplesinvolvingtheseenhancementsarestartingtoappear.

    CMJ

    http://www.canadianminingjournal.com/features/miningvaluationthreestepsbeyondastaticdcfmodel/ 3/4
    15/3/2017 MiningValuation:ThreestepsbeyondastaticDCFmodelCanadianMiningJournalCanadianMiningJournal

    http://www.canadianminingjournal.com/features/miningvaluationthreestepsbeyondastaticdcfmodel/ 4/4

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