Reader JP sent me this question (edited slightly to shorten):

I’m wondering if you do back-of-the-envelope calculations to determine the potential value of a company? If so, what inputs do you use? I’m assuming the best way would be to find another similar resource, hopefully within same jurisdiction, where a mine was already built to gauge the costs. Obviously, nothing is exact but at least an investor would have a ballpark idea of the potential value.

 If you don’t use back of the envelope calculations at all, are you solely basing when to exit on news releases and follow-ups with management?

Overall, it would be nice to be able to build a back-of-the-envelope model to gauge potential return or even make a determination early on if it’s worth sticking around.

Having an exit strategy is a good idea. What goes up always comes back down. I’ve also read 80% of investors often don’t turn their paper gains into realized gains. Knowing when to get out is pretty important, after all, we don’t put all the time and effort into researching a company to come up empty handed in the end.

It took a lot to answer this question, because it really asks: how do I decide if an advanced discovery is a good investment opportunity?

Answering that question should take a lot because it requires me to explain my entire process for stocks of this stage.

I’m happy to do so. Before I start, I want to emphasize that this is written for projects at the stage JP references – those approaching or with new maiden resources. I emphasize that because my process differs for pre-discovery, new discovery, or mine plan stage projects. Many of the concepts still matter but the valuation considerations differ.

Red Flags, Valuations, and Opportunities

For better or worse, I do not build valuation models. Certainly many investors do and they use the results to guide their stock expectations.

My approach differs. Instead of trying to model how a maiden or evolving resource might be mined, including estimating all the many and varied approaches and costs in building and operating a mine, I look at red flags, stage and pending milestones, and comparable projects.

If I see a growing new discovery or maiden resource that looks interesting, I immediately start trying to poke holes. I want a discovery to work as much as the next person but the market knows that a deposit only ever has a chance of working as a mine if there are no major stumbling blocks along that path.

• What is the metallurgy? Leaching – on a heap or in a plant? Any complications like the need to agglomerate or high acid consumption? Milling – via a simple conventional flowsheet or a complicated one? Recoveries – low, medium, or high? Metal in the ground is not valuable if the process to separate that metal from the rock is complex, expensive, and/or not very effective.
• What shape is the deposit and how will it be mined? Open pit – what is the strip ratio? High strip ratios require high grades to carry the extra cost. Underground – bulk or selective (wide or narrow zones)? Steeply dipping or flat lying (gravity helps move ore with steep deposits; flat-lying zones usually require more handling)? One mining area or multiple? How easy or complicated will it be to access enough ore and move it out of the mine (one ramp, two ramps, shaft, combo?)
• Does it seem like a mine could be permitted? What regulators are involved (BLM, Forest Service, US Army Corps of Engineers (if there’s a river, creek, etc), municipal, state? Are they generally functional with respect to mining permit requests in that area? Are local populations familiar with mining? Are there parks or protected areas nearby? How close is the nearest town?
• Where is the project and what infrastructure exists vs would have to be built? How much roughly would those projects cost and would those they present permitting risk? (Ex: a significant new road or power line or water demand)

Identifying red flags then lets you consider whether the deposit in question is good enough to be mined. ‘Good enough’ relates to size and grade.

If the questions above do not return a red flag, an imperfect deposit might work, perhaps one that’s low grade but has scale, has moderate grade and scale, or is high grade and small.

If the questions above do return a red flag, the deposit must be pretty good quality to handle the burden: moderate grade and large scale or high grade and moderate scale. Low grade deposits struggle the most to get over challenges – they can work (lots of porphyry deposits are pretty low grade) but it’s not easy and many don’t.

If the deposit is perfect – high grade (relative to deposit type) and large, for instance – it can handle some red flags. Ideally, of course, a deposit is fantastic and has no red flags!

Once an asset passes the red flags process, I move on to what the asset is worth. And even though it seems valuation should be a calculation, I find this part the hardest to determine.

JP is right that the most useful inputs come from comparable projects. If you are building a mine model, similar new mines in the area can provide all kinds of costs, from labour to tires to power, and parameters, like energy to crush to a particular size or reagent consumption on processing.

As I said, I don’t build mine models. I use similar new mines in the area as another red flag assessment (did it encounter any?). And I use similar, slightly more advanced projects in the area to see how the market feels about such assets.

This is where things get hard to pin down. If similar, slightly more advanced assets have much higher valuations, the project you’re assessing might have a weakness you haven’t figured out or might not have been noticed in the market yet. The former is a red flag; the latter is an opportunity, as long as you think management will be able to attract attention.

The other hard-to-pin-down factor is exploration potential. If you are assessing a new discovery around the time of its first resource, the count gives a starting point for valuing the stock but valuation is also about what the market thinks the deposit might become.

That gets complicated. It requires one to understand geology, how open the deposit is and how strong the reason to believe mineralization continues in each direction, how targeting has worked to date at the property, what targets the company will test next and why, whether the company has the cash to do that work, and whether exploration will continue largely uninterrupted or whether seasonality puts work on pause for months (snow, big rains, heat and drought, etc.).

At the end of the day, investment opportunities for projects close to first resource come in two types.

1. Market hasn’t noticed the opportunity yet. This could be because of a lack of marketing means few people know the story, because a complicated mineral system makes it hard to see how much mineralization they’ve already drilled, because the market is concentrating on one part of the story but hasn’t realized another big emerging part, or because overall metals investment sentiment is weak.
2. The resource is only the first step in defining a much larger deposit. As the deposit grows the stock should gain value, assuming the deposit is good (no red flags) and the market is paying attention / metals investor sentiment is reasonable to good.

Both can work well. Opportunities in the first category are riskier, as they require the holdback to be addressed: the company must start marketing effectively, the team must figure out how to explain the system or publish a surprisingly strong resource, the new part of the story must generate exciting results that amplify the overall potential, or the weak metals market must turn around.

Opportunities in the second category are the best. You invest after discovery and some drilling, which reduces exploration risk notably, but before the discovery has flexed its muscles, which leaves lots of room for value growth if those muscles impress. You miss the discovery share price lift, but discovery lifts are much more volatile than the ascent that happens as drilling turns a discovery into a deposit that looks mining-worthy.