Understanding Mining Stocks

Is it a good idea buy the stocks of companies that mine for gold and silver?

by Larry White of the Gold & Silver Education Center

A question that someone learning about the gold and silver markets for the first time might ask is  — Is it a good idea buy the stocks of companies that mine for gold and silver?  On the surface, it might seem like a fairly simple question. In reality, the answer can be a bit complicated. Investing in mining company stocks is definitely a more complex decision than simply making an investment in gold or silver itself. In this article, we will delve into some of the pros and cons so that potential investors can decide for themselves if it makes sense for them to invest in mining stocks.

Investing in gold or silver is a fairly simple decision for most people. While there are some different ways to to invest, most people probably just think of investing in gold or silver as buying some of the physical metal one way or another. Once its purchased, it just goes up and down based on the market prices for gold and silver. So for the most part, you only need to try to understand the factors that impact the price of the metals. Timing when to buy and sell may be a factor for some if they are trading.
Investing in the stocks (or options if you really like a lot of leverage) of gold and silver mining companies is more complicated. It requires the investor to have a broader base of knowledge and information. While the price of gold and silver is certainly a major impact on the stock price of a mining company, there are many other factors that come into play. They should be well understood by a potential investor. Let’s look at some of the other important other factors to think about:

  • The management team. This is very important for any company of course. For mining companies you want to look and see if the key management has a strong history of performance and a good track record in the industry. The decisions managements make about where to mine, how to mine, how to best utilize the available capital of the company, and whether to not to try and grow by acquisitions or through exploration for new reserves can have a huge impact on the success of the company and of course the stock price.
  • What kind of company is it? Start up or already producing? Mining companies go through life cycles. First they have to find gold or silver reserves in the ground. That takes capital and start up type companies have to raise that money. That means they will likely be issuing new additional shares of stock or will have to borrow money to fund the hunt for reserves. If a company does find reserves that can be projected to be mined profitably, they can either try to move forward and build a mine themselves or hope to attract a larger company already producing to buy them out. If they are bought out, you will then either own some stock in the company that takes over or you can just sell out your stock. 
  • Clearly, how successful a startup company is at finding new reserves is the most critical factor in its stock price early on in its life cycle. If a company moves on to become a producer, it will once again have to raise significant funding to build a mine. Once a company establishes a profitable producing mine, it changes into a less risky investment that depends more on the price of gold or silver to impact its stock price. It’s possible to invest in mining companies in all the various stages of their life cycle and make a profit. Generally, the earlier in the life cycle, the more risk is involved. But there is also more potential for abnormally large gains if the company successfully proves up significant new gold or silver reserves.
  • What quality are the gold and silver reserves?  Reserves of gold and silver are not all the same. The grade of the reserves can vary quite a bit. Grade means how many grams of the metal are in each ton of soil and rock they are mixed with in the ground. Gold, which has a much higher price, can be found in lower grams per ton than silver and still be profitable to mine. Another factor in the quality of the reserves is the kind of rock and soil the metals are attached to. One of the producing costs of mining is the separation out of the metals from the soil and rocks. The easier it is to do that, the lower the cost. The lower the cost, the more profit. In general, the more profit, the higher the potential for the stock price. 
  • The break even price of gold or silver for the company. Many mining costs are fixed no matter how many ounces of gold or silver the company may produce. This means that as the price of gold or silver goes above the “breakeven” price point, any further price increases tend to go directly to bottom line profit. So the break even price point for a mining company is important information for the investor to know.
  • Where are the company’s mines located? This can be a huge factor in some cases. Some countries have a long history of supporting mining activity and abiding by the rule of law and contractual agreements. Other countries may be higher risk in that regard. Investors need to understand those risks. It’s also good to know what tax rates apply and any royalty rates if those are involved.
  • How can you try to “value” a mining company? Here we are trying to figure out if the stock price of the company is properly in line with the value of its reserve assets. The stock market is impacted by all kinds of things including investor emotions. At times a stock price might go well below the reasonable market value of the  reserve assets of a company or go well above that. If an investor can get a reasonable feel for the true market value of the reserve assets of the company, that is a big help. There are many formulas used to try and do that. One is a simple cash flow and/or earnings per share calculation. How much positive cash flow does the company generate for each share of stock it has issued? How much net profit per share? Then you can apply standard multiples of those numbers to see if they stock price seems reasonably in line (or not) for the industry.
  • Another valuation method that is more complex is the Net Present Value (NPV) estimate of the company per each share of stock it has issued. Most commodity based companies use this kind of analysis to determine what price they might pay to try and buy reserves from another company. It requires estimating the future cash flows of the company 10 years or more into the future by estimating what the revenues and expenses will be over that time period. Then, the total positive cash flow is discounted back to the present day using an acceptable discount rate of return (say 6%).  The resulting discounted future cash flow total is then divided by the number of shares of stock outstanding to get an idea of a reasonable stock price for the discounted future cash flow stream. Knowing this can be very valuable in potentially finding a stock that could be significantly undervalued in the stock market (or overvalued as well). Usually, over time a stock price will revert back towards this NPV based value if it is way out of line in either direction.
  • Here is an example of a mining company presentation called a PEA (Preliminary Economic Assessment). This takes a mine and projects out its future cash flows based on what is known today so investors can have some idea what the potential might be over the life of the project. If you go to page 23 of this presentation, you can see an example of projected future costs and cash flows to get a sense of how this works. Assuming the company comes close to meeting these projections, you could take the discounted value of this future stream of cash flows and divide by its shares of stock issued to see if the current stock price is in line with that projection. It is just an estimate, but a useful estimate to make.

The video below does a good job of discussing many of the points listed above and provides an illustration of the NPV method for valuing the future cash flow stream of a typical mining company. 

There is no reason for someone new to the gold and silver markets to fear investing in the stocks of mining companies. They can provide a leverage for larger gains when the sector is in a bull market environment. The reverse is true if the sector is in a bear market mode. The leverage tends to work both ways. Individual companies can outperform or underperform the overall sector, but there are also indexes that allocate risk across multiple mining stocks that investors can look at as well. Examples are GDX and SIL
Generally speaking, large producers who have been in business a long time are less risky and volatile than mining companies that are early in their life cycle and less established. It is also true the early life cycle companies can provide even higher leverage for gains if they are good at finding new reserves of gold or silver. Sites like 321gold specialize in covering early life cycle mining stocks. The key is for the investor to fully understand what kind of company they are considering and to consider the kinds of factors listed above while researching a potential investment. As with any stock investing, the more you know, the better investment decisions you can make. The purpose of this blog is to encourage understanding and education to make better decisions and not to offer investment advice or recommend any specific investment. Each person must evaluate what best fits their own situation.