The Use of Comparable Sales When Valuing Mineral Reserves
Comparable sales, since they measure transactions values, produce fair market valuations rather than fundamental valuations. However, publicly quoted arm’s length transactions of mineral assets are rarely available. And where they are, the information becomes dated very quickly due to the volatility of mineral prices. If a valid comparable sale is not available, fair market value will have to be estimated via Model 4, with subjective adjustments for factors that cause transaction value to differ from fundamental value.
As I mentioned above, comparable sales are indispensable for valuing speculative and exploration properties, where there is not enough information to perform a reasonable fundamental NPV analysis. For development and producing properties, comparable sales, when available, can provide a benchmark when calculating the fundamental value of the asset. They also take into account the market factor for reserve and other risk. While comparable sales need not necessarily reveal an asset’s fundamental value, they introduce discipline into the valuation process.
What About Political Risk?
Many mineral assets are found in developing countries, where political and financial instability detract from the value of the asset. Analysts often estimate an annual probability of mineral asset loss of up to 50% in some countries, the high value being a result of the tendency for nations to show force by nationalizing and “returning to the people” the mineral assets of foreign corporations operating within the country. I would suggest, however, that political and financial risk is, in this day and age, an unlikely event. The insurance rates charged by insurers of political and financial risk typically indicate a risky event probability of less than 2% per year. My own work shows that markets placed at only 1.4% the annual probability that the African National Congress, in the early 1990s, would carry out its threat to nationalize mining assets in South Africa (Davis 2001). Incidentally, don’t waste your money purchasing political risk analysis from the various companies that offer it. Their track record in predicting risky events is horrible.
A typical approach to dealing with this risk is to add a political risk premium to the radr. As ad hoc as it sounds, there is theoretical support for this approach, but only if the following rules apply: the project has a long life; the risk is of permanently losing the entire cash flow stream; and the annual probability of losing that cash flow stream is constant. While this may sound like a lengthy laundry list, it applies in some cases, and when it does, the appropriate impact of political risk on valuation is taken into account when the radr is increased by this annual probability of permanent cash flow loss.
The next issue is the amount by which to increase the discount rate. For fully diversified owners of the asset, if the annual probability of permanent cash flow loss is 2%, then the discount rate should be increased by 2%. Fully diversified equity owners, for example, would wish that mineral asset managers use this increment when assessing foreign projects. Undiversified asset managers, on the other hand, will use a higher risk adjustment factor, the same project insurance premium effect that I discussed earlier. Here, again, fundamental value recognizes the diversified nature of shareholders, and recommends a relatively small premium in the discount rate for political risk. Fair market value, on the other hand, will take into account that the transaction value of the asset is impacted by managerial risk aversion on the part of both buyer and seller, which will lead to a higher discount rate and lower asset value.
