Evaluating properties that have no proven reserves

From a presentation by Ross Lawrence, P.Eng., to the Toronto Geological Discussion Group.

There are three broad categories of accepted valuation methodologies: income, cost and market techniques. All techniques of determining future benefits and calculating their present value will readily fall within one of these three approaches. Valuations in the mining industry may be required for mineral properties for which the available information may vary over a very wide range. At one extreme we have lands on which mining production is already taking place. In this instance, sufficient information usually exists to establish fair market value using discounted cash flow techniques. In the most elegant case, proven reserves are required to take this approach. Naturally when one does not have proven reserves but has other kinds of mineral inventory, then we start sliding toward the other end of the range.

At the other extreme is a relatively unexplored mineral property on which mineral deposits are not known but which have sufficient perceived potential value to warrant exploration. The techniques value such assets are generally much more subjective.

Between these two extremes lie many types of mineral assets at various stages of exploration and development. Projects for which proven and probable reserves have been well-defined but for which development is not planned until market conditions for the mineral commodity improves require special treatment.

Another important consideration in dealing with a going- concern company is that a value should be placed on the knowledge and experience of the management and staff and upon certain other assets such as exploration files, information resources and so on, all of which are intangible assets.

The income approach to valuation usually involves the calculation of net present values of projected net cash flow. Such calculations are heavily dependent on the accuracy of cost estimates, the assumed future selling price of the product and the discount rate used. In the case of development projects which have not yet reached the feasibility study stage, other important components in the valuation include the quality and reliability of the work performed, the stage of development, the probability and timing of a production decision and the location of the project. In most instances, the degree of risk associated with these components is reflected in the choice of an appropriate discount rate.

On the subject of discount rates, it is our view that the two factors of metal price and discount rate are interdependent and can be considered by reference to an analysis of current stock market activity. This is the real market as opposed to the notional market in which the valuator is usually working. For example, on any day the price at which a particular gold mining share trades on the stock exchange is a reflection of investors’ perceptions of gold prices, their assessment of the risk associated with that company and their requirement for an economic return commensurate with these perceptions and risks.

In our projections, Watts, Griffis & McOuat invariably use constant dollars of the year in which the valuation date lies, with no future inflation escalation. In each case the metal prices selected are used throughout the life of the project and we are inclined to the use of current prices with perhaps some adjustment if there is a strong case to be made for a short term aberration. No attempt is made to forecast future prices.

Turning now to methods which can be categorized as the cost approach, the first method to be considered is one which has been called the appraised value method. Bill Roscoe of Roscoe, Postle Associates has written a number of papers describing this approach and we have found this to be a very useful tool in valuing exploration properties where ore reserves have yet to be outlined.

The fundamental requirement for this approach is that the valuator must be an experienced exploration geologist inasmuch as it is very much a subjective approach and the judgment of the valuator is the prime element. This factor is often overlooked when considering the results of such valuations and thus I cannot stress too strongly the fact that it must be done by an experienced geologist.

Each exploration property is considered by itself and one begins by determining the cost of recent exploration work annually over the last 3-4 years and looking at the budget approved for the next ensuing year. Geological reports are examined and the results evaluated.

The appraised value approach involves two key assumptions, (1) that a property’s value is either enhanced or diminished by an exploration program, and (2) that funds already expended on a property of value and those to be expended in the next period will produce value in today’s dollars which will be no less than the expenditures made.

Expenditures made on ground later abandoned due to negative results cannot be used. Where exploration results are positive, the expenditures can be retained as value added to the property. In order to deal with this in a logical fashion, we normally prepare a guideline to indicate what percentage of the retained expenses is to be included as value. Thus in cases where the results are very positive, more exploration is warranted and funds have been budgeted for the next period, then 100% of the costs will be included as value. Where no immediate program has been budgeted and sub-economic resources have been identified, perhaps 75% might be retained. Where no immediate program is budgeted and no specific resources have been yet identified, but where the property is being retained and specific exploration potential remains, we might include up to 50%.

Where things are essentially negative but the property is still not completely tested, then perhaps 25% would be retained. These are general guidelines and again the geologist’s independent judgment must be the prime input. In all cases after all of the factors above have been taken into account, the retained expenditures are inflated to present day dollars by reference to usually the GDP implicit price index.

Another approach to dealing with exploration properties has been termed the technical evaluation method and results from some work which Lionel Kilburn did to assist him in dealing with properties being submitted for approval by the Toronto Stock Exchange. This is another cost approach to valuation and is based on the fundamental concept that a property is normally acquired in the first instance by staking and thus one can take the cost of staking a claim, say $400, and then multiply this value by appropriate qualitative factors to obtain a valuation of the property.

Usually we use four such factors namely, location, grade, anomalies and geology and rate each of these on a scale of one to six.

For instance, if we established that location was worth four points, geology three, mineralization two points and anomalies two points, we would then multiply four times three times two times two and $400 a claim to arrive at a value for such a claim of $19,200. This is not an elegant approach but we have found it to be quite useful in dealing with certain kinds of exploration properties.

I would like to turn to several market approaches. These are the most direct and most easily understood appraisal techniques. We measure the present value of future benefits by trying to obtain a consensus of what others in the marketplace might judge these benefits to be. Market approaches usually require that there be a fairly active market, that the market be public so that one can obtain data, that sufficient detail be known so that judgment can be made as to the degree of comparability and also that one may make adjustments for time in those cases where the sale information is not contemporaneous with the appraisal.

The first method I would like to describe is what we call farm-in commitment analysis. Such farm-in commitments are not often absolutely binding as there are always rights of withdrawal. However once the fa
rm-in is agreed, the expenditure commitments must be met in order to determine the probability that the full expenditure commitment will be met. These commitments can then be discounted to current dollars and adjusted by the percentage equity being earned in order to calculate a fair market value for the total property.

Of course, if one can obtain examples of truly comparable transactions, then the task becomes much easier. Thus comparable transaction analysis should be the first methodology within the market approach that one seeks to use. However, it is rare to find such transactions being carried out on a strictly cash basis in the mining industry. One usually has to examine blocks of shares or option agreements and then try to convert these into cash. The date of the transaction is critical to this type of analysis. It should be as close as possible to the valuation date because transaction values are obviously heavily affected by such variables as metal prices, new developments in exploration philosophy, new discoveries in specific areas and many other factors, all of which are time-related.

For example, a spectacular discovery in a new area such as Hemlo will create demand that has a substantial affect on property transactions in that area. Some valuators are of the opinion that inflated prices paid for property in such fashionable areas immediately after the discovery, should be discounted in this type of analysis. We are of the firm belief that such prices should not be discounted because they do reflect the true market value of a property at the time of the transaction and thus have a direct impact on value on the valuation date.

Similar transactions can be compared and expressed in a number of ways other than straight property sale. A number of these guidelines have been widely developed and used over the past few years when gold has been of such over- riding interest. So we have such rules of thumb as the price paid per ounce of gold in the ground or per recoverable ounce of gold, a dollar value per ounce of annual production which can sometimes be useful in looking at properties with ore reserves but which are not yet into production.

For properties without reserves, or with commodities other than gold, the comparison can also be done on the basis of dollars per unit area of favorable ground with the emphasis on favorable. Another method is to determine the comparable value of the ground based on the value of expenditure commitments as described previously. This is particularly valid if a third party has recently negotiated an option agreement on the subject property.

Ross Lawrence is executive vice- president at Watts, Griffis and McOuat, consulting geologists and engineers. file: H:G:MINES NT Hemlo/Central Crude Dec 21 Sure

Hemlo Gold Mines (TSE) is a firm believer in the Mishibishu gold camp west of Wawa, Ont. The big gold miner is taking down a 750,000- share private placement in Central Crude Ltd (VSE) at a price of $6 per share. Hemlo has also agreed to purchase another 750,000 shares at $7 per share within 12 months, both companies say. That’s a $9.75-million deal.

Also, Hemlo has agreed to provide additional funding of up to $18 million which will take care of Central’s share of any future capital expenditures required to place Eagle River property into production.

In return for providing the future funding, Central has issued Hemlo Gold 1.5 million share purchase warrants which give the company the right to buy one share from treasury at $7 per share.

According to Central Crude President Richard Nemis, the Hemlo Gold deal will provide “access to sufficient capital to cover our anticipated needs.” The company has 5.46 million shares issued and outstanding. The Hemlo Gold deal, if fully exercised, will result in 8.5 million shares outstanding. Hemlo would then become the major shareholder, with a 44% interest.

Hemlo, which acquired a 60% interest in the large property, has met with success from exploration. Hemlo has discovered several gold mineralized zones displaying the potential for hosting significant tonnages.