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Must-know: An overview of the iron ore industry

Part 13
Must-know: An overview of the iron ore industry (Part 13 of 13)

Overview: What valuation metrics should mining companies use?

Valuation metrics

Since mining is a highly cyclical industry, investors should identify the stage of the cycle in which the industry is currently in, to be able to apply different valuation metrics. However, since it’s quite difficult to predict the inflection points at which the cycle would turn, sensitivity or scenario analysis could be done by giving different probabilities to different scenarios.

CyclicalEnlarge Graph

DCF based approach

If the  scenario seems more or less like a base case, then the discounted cash flow (or DCF) based approach could be used. If the company has few mines then even mine by mine DCF could also be used. However, choosing the base year could be difficult, so don’t always go for the last reported year as the base case. Instead, look at normalized earnings and use that to forecast earnings going forward.

Multiples based approach

Multiples like price earnings (or PE) or enterprise value (or EV) to earnings before interest, taxes, depreciation, and amortization (or EBITDA) could be used to value one company based on its own historical multiples or peer companies’ multiples. You would apply a premium or a discount, based on the stage of cycle, quality of earnings, and leverage ratios. The EV to EBITD multiple would be of better value for mining companies than EV to EBITA, because capex for these companies tend to be quite lumpy and, the depreciation depending on the timing of capex, EV to EBIT will give a very distorted valuation comparison. However, one shortcoming in the earnings based multiple method is that it could be driven by the commodity price assumption taken in that particular year. EV to reserve is also used for valuing mining companies because it’s very difficult to assess the exact amount of deposit, so their valuations follow the market value of its reserves and companies with proven track record of successful exploration command premium.

However, along with valuation metrics, investors should look at the factors affecting each company, such as Rio Tinto (RIO), BHP Billiton (BHP), Vale (VALE), Cliffs Natural Resources (CLF), and the industry as a whole to form a wholistic view before investing. Investors might also want to consider the iShares S&P Global Materials Sector Index Fund (MXI), which invest in these companies.

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