Real options—the application of financial option pricing theory to the valuation of real assets—is all the rage, and its first application was to the valuation of mineral assets, back in 1979.  In theory, at least, real options serves to describe the attributes of all classes of mineral properties much more appropriately than NPV analysis.  The reason for this is that mineral properties contain within them option-like opportunities that are not valued by NPV analysis.  It is well known within the industry, for example, that well-conducted NPV analysis tends to undervalue mining company equity (Davis 1996). The result is that a mineral asset’s fundamental value usually is worth more than its NPV.  This added value can only be uncovered using real options techniques.

In practice, however, calculating this added value is extremely difficult.  There are short-cuts that the business schools are teaching their MBAs, but these shortcuts create such valuation error that we really can’t rely on the numbers.  Beware real options consultants bearing simple solutions!

Real options theory does, however, solve a conundrum that I raised earlier.  Mineral investments must generally clear a 15% or so hurdle rate before they are undertaken, and yet the return to holders of traded equity (shares) is on the order of 7%.  How can this be?  One answer, which I don’t think is correct, is that firms either pay more than the fundamental value for properties, or that the projects undertaken are less productive than originally thought.  A better answer is that well-diversified equity holders of listed mineral firms recognize that mineral assets contain real options that significantly lower the risk of their investment.  For example, equity holders face limited liability, yet get full participation in upside.  There are also options to shut-down or abandon loss-making properties, which again limits equity-holders’ downside losses.  These option characteristics add value, and equity holders, recognizing this, bid the equity up to its “real options” value.  In turn, they also recognize that the options reduce risk, and only require a return of 7%, the required rate of return for assets (options) of this lower risk class.

 All of this means that the link between mineral asset fundamental value and mineral firm equity is indirect.  Fundamental mineral asset valuation via NPV misses some of the value inherent in the flexibility afforded to mineral asset operators, and yet the equity markets reflect this value.  Fundamental valuation via NPV also misses the reduction of risk that this flexibility brings to a project, and yet equity markets are aware of and take this reduction into account.  For this reason, traded mineral company equity would appear to be worth more than the sum of its parts—the aggregate fundamental value of the underlying mineral assets—but this is not the case.  The underlying assets are simply undervalued by decision makers who demonstrate their risk aversion using very high discount rates.  I am not advocating that valuators jump on the real options bandwagon, but am merely suggesting that real options may explain these puzzling differences between fundamental asset valuation at the level of the project and equity valuation in the market.