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DecisionNext Blog

Value: what’s your downside alongside the upside?

Published by Bill Hart December 15, 2017

With commodity prices cooling, and long standing investors un-impressed with low returns from the greatest boom the mining industry has seen existing players move to protect profitability, shed non-core assets, return capital to investors, and above all…

...ensure their long term survival.

Interestingly, at the same time, billions of dollars of private and sovereign equity is being amassed outside the existing mining houses with the intent of deployment in the resources industry, and more precisely to take advantage of the potentially attractive asset prices that are expected to occur at the perceived impending cyclical low point.

That is, current owners are contracting, and new entrants are poised for action.

From a value perspective, most mining companies are essentially high capital, long term investors in mining assets, and where and when they choose to deploy their capital critically shapes their ultimate investment fortunes.

The reality is that there are many sources of value creation in mining, as there are in all industries, with the ultimate choice critically dependent on natural advantages and the competencies that a business is prepared to apply fully.

Much can be learned from how mining companies have created value in the past.

In interpreting this analysis, two further questions need to be overlaid:

  1. What is relevant to a firm’s particular situation, most importantly its existing competencies and assets?
  2. How might value creation opportunities shift due to future trends and events in the external environment?

Before examining sources of value creation, it is necessary to clarify what we mean by value creation in mining.

Ultimately value is measured by discounting expected future cash flows, which loosely translates into enterprise value, and then share price after liabilities are accounted for. This definition is broadly accepted; however the complexity lies in the assumptions regarding future cash flows, and the capital investments required to achieve these. This presents two problems:

  1. In mining, most value is ultimately created through subsequent brownfield expansions, but this “option value” is often poorly represented in initial mine valuations.
  2. Mining is notoriously cyclical, and human beings are universally prone to extrapolation, so expected value is almost always underestimated at low points in the cycle, and overestimated at high points in the cycle (there are plenty of examples from the most recent mining boom).

Rather than focusing on precise definitions of value, it is probably more beneficial to focus on the uncertainties that arise in mining given their relative impact.

When assessing the sources of value creation potential, it is an axiom that value upside potential comes with value downside potential…

and the upside and downside are not always symmetrical.

However, mining is by definition an industry where incumbent assets are depleted, so calculated risk taking in pursuit of value growth is an unavoidable part of the business, if the business is to be sustained – this is why mining is seen as high risk by investors who look at a broad range of asset classes.

The key to successful strategy therefore is not so much about avoiding risk, but is in having the capability to manage the risk associated with chosen growth pathways.

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