Today we are going to explore how to analyze the financial strength of gold companies using the Gold Investor Pro report
SmallCapPower | March 30, 2017: In Part 3 of our Excel How-to series, we are going to explore how to analyze the financial strength of gold companies using the Gold Investor Pro report. If you missed the opportunity to view the prior sections, click here: Part 1, Part 2.
Mining is a capital-intensive business, with significant costs stemming from the acquisition of properties and royalty fees to stripping and drilling costs. As a result, gold companies take on debt in order to finance their exploration, development, and production endeavors. However, not all debt is treated equal, as companies vary in their debt structure, revenues, and leverage. Thus, some companies entail more risk than others, such as exploration phase stocks that have yet to produce their first gold pour and revenues. Yet, these same high-risk exploration stocks have the potential to yield the greatest returns!
View the Gold Investor Pro: Top 34 Gold Companies Analyzed
In Part 3, we will explore financial ratios such as debt to equity, debt to EBITDA, and cash burn rates. This will allow us to compare the financial performance of each company against its industry peers in our Gold Investor Pro Report to find those stocks that may be undervalued.
Debt to Equity (D/E)
A widely-used financial ratio to measure the riskiness of a company’s financial structure is the debt-to-equity ratio. The calculation reveals the relative proportion of debt and shareholders’ equity a company employs to finance its assets, usually as a ratio or percentage. Although debt is widely considered the cheapest form of financing, a high-debt gold company may be overwhelmed to service its payment obligations in a bullion price downturn. Additionally, a high-debt profile also limits a company from being able to borrow more from lenders and creditors, which reduces their financial flexibility.
A low debt-to-equity ratio indicates lower risk, and signifies the company’s ability increase leverage if need be. A higher debt-to-equity ratio, on the other hand, shows that a company has been aggressive in financings its growth with debt, and there may be greater potential for financial distress if earnings do not exceed the cost of borrowed funds.
To calculate the D/E ratio, divide total liabilities of the company by its total shareholders’ equity. This has already been done for you in the ‘Market Data’ Excel sheet (AM-4). Below, we show you how to filter for the gold companies with the lowest debt-to-equity ratios. As you can see in Figure 1, Endeavour Mining Corp. (TSX: EDV), Gold Standard Ventures Corp (TSXV: GSV), Dalradian Resources Inc. (TSX: DNA), and Lundin Gold Inc. (TSX: LUG), all have a D/E ratio of 0x, implying they have no debt.
Figure 1: Using Excel to Filter for Low D/E Ratios
Debt to EBITDA (D/EBITDA)
The Debt-to-EBITDA ratio calculates how many years of earnings a company would require to service its current debt obligations. It is a leverage ratio that measures a company’s ability to pay off its incurred debt, ignoring factors of interest, taxes, depreciation, and amortization. For more information regarding EBITDA, check out our explanation in Part 2 of our Gold Investor Pro How-to series.
This metric is commonly used by credit rating agencies to assess a company’s probability of defaulting on issued debt. Hence, a high D/EBITDA ratio suggests a company may not be able to service its debt in an appropriate manner and warrants a lower credit rating. For example, if Company A has $100mm in debt and $10mm in EBITDA, the D/EBITDA ratio is 10x. If Company B has $60mm in debt and $5mm in EBITDA, the D/EBITDA ratio is 12x. In this case, Company A would be less risky as it has a lower D/EBITDA multiple, and may also have a higher credit rating.
To manually calculate the D/EBITDA ratio, divide total debt (short-term and long-term) of the company by its EBITDA (net income + interest + taxes + depreciation + amortization). Fortunately for you, this has already been calculated in the ‘Market Data’ Excel sheet (AK-4). Below, we show you how to filter for the gold companies with the lowest debt-to-EBITDA ratios. It is worth noting that companies operating at a loss will have a negative D/EBITDA, implying an even riskier business. As you can see in Figure 2, Alacer Gold Corp. (TSX: ASR), Dalradian Resources Inc. (TSX: DNA), Lundin Gold Inc. (TSX: LUG), and a few others all have a D/EBITDA ratio of 0x.
Figure 2: Using Excel to Filter for Low D/EBITDA Ratios
Cash Burn Rates
Many gold companies, such as those in the exploration or development phase, have yet to earn income and thus operate at a loss. This is because these companies are focused on property development and, ultimately, proving an economic deposit. As a result, exploration companies invest heavily in drilling and exploration campaigns to increase the quality and quantity of their resource base.
Cash burn rates, or burn rate, refers to how fast a company is losing money, which is a negative number computed monthly or quarterly. This is extremely important when a company has limited sources of funding to cover losses. If a company has a constant burn rate and a finite amount of cash, it will eventually run out of money. In accounting terms, cash balance is a balance and burn rate is a flow. Burn decreases a company’s cash balance—the amount of money a company has at any given point. ‘Runway’ is the time a company has until it runs out of money, which is calculated by dividing the cash balance by the company’s burn rate. For example, if a company has $500k in cash and cash equivalents (CCE) and will burn $25k/month, it has a runway of 20 months. After these 20 months, if the company is still in an exploration stage then it will have to raise additional financing (usually equity) in order to stay afloat and continue exploring.
As you may have guessed, a higher burn rate generally entails more risk. To calculate a company’s burn rate, divide its annual cash flows from operations by 12 for a monthly burn rate, or 4 for quarterly. Then divide the company’s cash and cash equivalents (CCE) by its burn rate to find the runway. These calculations are already included in the ‘Market Data’ Excel sheet, in the column titled ‘Burn Rate (quarterly) and ‘Runway (quarterly).’ Since our focus was on producers, most of the companies (besides 5) have positive operating cash flows; therefore, they don’t have a cash “burn” rate. This burn is usually only applicable to exploration and early development-stage companies that have yet to generate cash from operations.
As you can see in Figure 3, Lundin Gold Inc. (TSX: LUG) has the highest burn rate at US$14.3mm/quarter. With a cash balance of US$9mm, Lundin Gold has a runway of 0.6 quarters (US$9/US$14.3) before it would have to find new financing.
Figure 3: Using Excel to Calculate and Filter for High Quarterly Burn Rates
When analyzing gold companies, no single multiple or valuation technique will isolate the best stock in which to invest. Instead, a collaborative approach must be adopted, where we employ qualitative measures, valuation calculations, and a financial analysis.
Now that we have gone through all three parts of our ‘Excel How-to’ series, it is now time to apply the learnings to the spreadsheets. Take some time to sift through the data to find those companies with the relative risk and return profiles that match your investor appetite for risk and reward.
Stay tuned for next week, when we will have one of our leading research analysts provide his own expert valuation as to which gold stocks are likely to outperform their industry peers!