LETTERS TO THE EDITOR — The difficulty of pricing a stock

Regarding the letter “Beware of pessimists, investors warned” (T.N.M., Sept. 6/93), certain comments were made by the author which warrant a response.

It is clear from the comments and numbers that Wayne Fipke does not have any understanding of economics or the valuation process under which stock prices are made. No credible analyst will determine a value for a potential deposit using the methods espoused by Fipke.

Using an average grade for a deposit to determine the value per ton of ore and then subtracting an estimated cost per ton to mine the mineral in order to derive a value for a particular company’s share is not only misleading, it is outright wrong for anyone with a credible position within the industry to promote this type of valuation process publicly.

During the 10 years in which I have undertaken many financial and economic analyses of both mining and oil and gas projects, as well as detailed market valuations of public companies, I have found the major determinant for stock value to be related to the level of cash flow generated by a company’s assets, and not the implied value of its assets.

Any value associated with gold, copper, silver or diamonds in the ground is predicated on management’s demonstrated ability to generate a cash flow through production of the mineral. If this cannot be shown, then the stock price remains low, and reflects the speculative optimism of the market that something can be done in the future.

An integral part of the valuation process is the expected timing of the cash flow. That is to say, a company generating cash flow will have a higher value than a company that is expected to generate the same cash flow at some point in the future (all other things being equal). Any investor who does not factor in timing is bound to be caught and lose.

Using net present value, an investor can determine the difference in value between those two companies mentioned in the previous paragraph by employing a hurdle rate that reflects the risk associated with the likelihood of the non-producing company ever being able to generate a cash flow equivalent to the producing company.

One issue separating the diamond industry from the rest of mining is the way diamonds are sold. De Beers controls a cartel whereby prices for diamonds can be maintained at artificially high levels. The strength of a cartel lies in its ability to control supply to the market. One serious threat to the diamond cartel is Russia and if investors fail to factor Russia’s position into their analyses, they are assuming a high risk.

It is difficult to justify Dia Met stock prices given the limited technical development to date and the uncertainty associated with future costs and grades of any mining operation. When the risk associated with future prices is added to the picture, that justification is even harder to imagine. William Olsson

Calgary, Alta.