Better managing #gold's stock performance | Deloitte Canada

over the past 10 years [there has been] a three- and sometimes four-fold spike in invested capital requirements per ounce produced.

working capital requirements have gone up due to increased post-production inventories because rising prices have made it more economical to process lower grades. 

Some gold companies have experienced total cash cost increases between 100% and 325%

Better managing gold's stock performance
Create value with comprehensive economic analysis

By Sunil Kansal

Investors typically expect the stock price of gold mining companies to be strongly correlated with the price of gold. But, since 1996, gold has increased by more than 400% in price while the performance of individual gold stocks has shown a wide range in trends and sensitivities.

There’s at least one response that gold companies can take to better manage stock performance: comprehensive economic measurement, otherwise known as economic margin¹ analysis. In our experience, implementing this kind of framework — which incorporates consideration of cash flow, investment and cost of capital — can help companies quantify the key drivers of long-term stock performance and, accordingly, support executive decision-making.

Many buy-side analysts are already doing it anyway and better value is created in the process. The explanation usually lies in the framework that allows for the measurement of net impact from all factors under the company’s control to lead to quantitative models. Those models in turn enable quantitative decision-making based on the intrinsic calculation of stock prices. Put another way, executives can use the framework to effectively predict the effect of various capital investments on the stock price.

At the end of the day, successful companies measure results, make decisions and set strategy with the goal of creating value.

A company’s performance measures must serve as a proxy for its market value creation. Economic margin is simply a more complete performance measure to guide performance and motivate employees.

What affects the price of gold
It’s no mystery that the price of gold is affected by myriad technical and fundamental factors, including the following:
Supply and demand;
Emergence of financial instruments;
Economic and company events;
Gold reserves and resources;
Costs of operations and capital.

Of course, everyone is affected by the commodity price; it’s the mixed performance of various stocks that exposes the company to specific factors playing a bigger role in the commodity-stock delinking phenomenon.

Gold consumption and supply
Between 1996 and 2011, annual gold consumption increased at a compound annual growth rate (CAGR) of 2.96% versus 2.37% for supply. That demand was driven primarily by investments in bars, coins and exchange-traded funds (ETFs), the latter of which in particular have enabled easy trading removed from the insecurity of physical gold. Supply during that timeframe, on the other hand, was constrained by decreasing average sizes and deteriorating quality of new deposits as well as increasing operational cost pressures.

Meanwhile, various macroeconomic events of the sort that directly influence gold investors’ behaviour (such as the recent global economic downturn) continue to have a strong impact on the spot gold price and contribute to both price volatility and deviations from long-term supply and demand fundamentals.

A three-fold spike in capital requirements
On the stock performance side, increased gold prices have resulted in higher revenues. On the other hand, declining grade quality has led to fewer ounces of gold being extracted from each ton of ore, resulting in lower average margin potential per ton due to higher cost of production per ounce. The challenges in finding high-quality resources, meanwhile, along with corresponding increases in the cost of exploration and development, have resulted over the past 10 years in a three- and sometimes four-fold spike in invested capital requirements per ounce produced.

Depreciable assets per ounce have also increased over the last 10 years at a similar scale on rising discovery, acquisition, construction and equipment costs. And working capital requirements have gone up due to increased post-production inventories because rising prices have nevertheless made it more economical to process lower grades.

It gets better – by which, I mean worse
Since 2000, operating cash flows of mining companies have been impacted by rising material and consumable costs. Some gold companies have experienced total cash cost increases between 100% and 325%. Those increases have in turn reduced the impact of enhanced revenues from the rising price of gold on operating margins to the tune of 34%-87% compared to the 400% commodity price increase.

Added to all of that, evidence also suggests that cost of capital has decreased by an average of 1% in absolute terms, leading to significant improvement in the valuation of gold stocks.
"Economic Margin Framework" is a trademark of The Applied Finance Group (AFG) and is used here with permission.

Read Sunil's feature article in the Spring 2013 edition of Canadian Mining Magazine.


Sunil Kansal is a senior manager in Deloitte’s Consulting practice. He specializes in mining.

Read the article on the Deloitte Canada site: Better managing gold's stock performance | Deloitte Canada


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