Comparing junior gold stocks based on ounces in the ground can help investors find the market’s most undervalued opportunities.
Although the price of gold has been trading rather flat in 2018, analysts are confident gold positive market conditions will continue supporting the yellow metal and even pushing prices higher as we move further into the year and beyond. BMO recently raised its 2018 gold outlook by 4 percent to $1,327 an ounce on rising inflation and geopolitical risk despite a stronger dollar.
While many a gold bug swears by storing wealth in physical metal, analysts will tell you there is considerable potential value to be had in owning gold stocks. In fact, BMO’s analysts see the current gold environment creating opportunities for investors in the gold equities market, especially for undervalued stocks.
“Macroeconomic, company fundamentals and valuation all point toward an opportunity for investors to benefit from increased exposure to precious metal equities,” said BMO analysts in a recent report. “A return to higher gold and silver prices may just be the catalyst needed to reinvigorate investor interest.” The bank’s favorites include mid-tier and majors such as Agnico Eagle (TSX:AEM), Endeavour Mining (TSX:EDV), IAMGOLD (NYSE:IAG, TSX:IMG), and Kirkland Lake (TSX:KL).
However, for those who can stomach a bit of risk if it means a higher chance of reward, junior gold stocks remain an attractive way to play the gold market–especially, the undervalued exploration-stage companies with plenty of upside potential for value creation.
Undervalued gold juniors
Gold stocks offer a number of attractive investment propositions. “One is they’re leveraged to the gold price through their operations or through their assets, but also these companies are able to create value through the strategic initiatives they undertake,” Doug Groh, portfolio manager at Tocqueville Asset Management, told INN at the Mines and Money conference in New York. “It might be expanding their operations or [making] a discovery and developing that discovery, or perhaps through M&A — and we see a lot of M&A in the marketplace, and we’ve tried to capture that opportunity as well.”
Groh added that although his firm had cut back on their exposure to junior stocks during the contraction of the last seven years, he believes exploration-stage companies are “a very interesting part of the gold-mining spectrum because these are companies that are certainly undervalued and can create significant value. And so we’re beginning to take a look at that a little bit more actively.”
But how do you evaluate and compare junior gold stocks to choose the best investment?
Mining asset valuation techniques
Investors often use valuation ratios to determine the true value of a potential investment as well as compare a stock against its peers in the market. A commonly used investment valuation ratio is the P/E multiple which compares the current price of a company’s shares to the amount of earnings it generates to give investors an idea of how much they are paying for each dollar of earnings. This may be a good tool for evaluating gold producers; but most junior gold companies are not yet generating earnings. Their greatest asset is still in the ground.
Junior explorers’ greatest asset is gold in the ground
Of course, there are a number of important factors an investor needs to consider when evaluating the investment potential of a junior gold stock. Most analysts will tell you to take a hard look for a tightly held share structure, experienced and successful management and technical teams, as well as the ability to raise funds without too much dilution of the stock—all critical to the ultimate goal of creating shareholder value.
“What we’re looking for is a company that’s going to create value, and typically the value is initially created through the assets,” said Groh. “The asset and the management strategy are very important, and of course the financial position of the company to execute that strategy is a primary concern for us.”
The most important piece of the puzzle centers on the value of the project itself. For a junior gold stock, their true asset value is the gold resources they’ve been able to delineate through drilling campaigns. In this way, the mineral resource estimate becomes a critical factor in evaluating a company’s worth. Growing this resource estimate and converting inferred resources to measured and indicated de-risks the project and builds investors’ confidence—and there is value in that.
If investors can determine the real value of an ounce of gold in the ground, they can better evaluate the investment potential of a particular gold exploration or development company.
Enterprise Value per ounce of gold in the ground
One metric investors may find useful when evaluating junior gold stocks is the Enterprise Value per ounce of gold in the ground (EV/Au Oz).
To calculate Enterprise Value, start with the market capitalization of a company (or the number of outstanding shares multiplied by the current share price) then add its financial liabilities (i.e. debt) and then subtract the company’s financial assets (i.e. total cash and cash equivalents). The result is the market value of a company’s projects. The final step is to divide that number by the known ounces in the ground contained in the company’s resource estimate.
EV/Au Oz helps to answer questions such as “How much am I paying per ounce in the ground?” and “How does this cost of this investment compare to buying physical metal?” EV/Au Oz can also be used to compare junior gold stocks to other peers in the market.
This mining asset valuation technique is of course not without its flaws and there are a few important caveats to keep in mind when using it. For one thing, it doesn’t take into consideration the costs required to build and operate a mine. Other variables at play include the size, depth, grade and metallurgy of a project; not to mention socio-political risks. The EV/Au Oz is most effective when comparing multiple companies who have projects with similar deposit characteristics and jurisdictions.
But the most obvious issue is that not all resources are created equally. The proven and probable reserves of a mid-tier gold producer are not the same as the measured and indicated resources of an advanced-stage explorer. Again, comparing like with like is the best strategy here. And giving more weight to those ounces with higher confidence can also help to paint a more accurate picture.
“We believe Granada Gold has been undervalued by the market compared to other companies in along the Cadillac trend in the Abitibi Greenstone Belt region of Quebec. Our enterprise value per ounce of in-situ gold resource (2.3 million ounces) is less than C$10 per ounce. When compared to other gold companies at a similar stage of development, it is clear that Granada Gold has space to grow,” said Frank J. Basa, President and CEO of Granada Gold Mine (TSXV:GGM), speaking of his company’s position as an undervalued junior gold company. The company has a pre-feasibility study on the property, which included reserves of 21.6M million tonnes grading 1.3 g/t gold.
Along with assessing geology, the team and the jurisdiction, mining asset valuation techniques such as EV/Au Oz can help investors determine which junior gold stocks represent the most undervalued investment opportunity.