Discounted cash flow (DCF) analysis is often applied to companies in the mining business because accurate evaluation of a company's worth depends heavily on projected future earnings. In the mining industry, profit is determined more by revenues than by costs. The operational costs of a producing mine tend to remain relatively fixed, while revenues from sales vary greatly depending on the market price for the mined ore. The most important figures for accurate DCF analysis of mining companies are the discount rate, operating costs (including capital expenditures) and projected future earnings. Projection of future earnings is further dependent on projections of commodity prices over the long term and on the grade of ore the company's mines produce.
To arrive at a more accurate discount rate, mining company evaluation factors into the discount rate risks associated with specific mining projects and country-associated risks dependent on mine location. Either of these risk factors can increase the discount rate by 10% or more. An important element of cost projections is the price of replacing equipment over time.
Because of substantial variations that exist in cost and revenue projections for different mining projects a company has, a proper DCF analysis of the company as a whole is only arrived at by first doing a separate DCF analysis for each of the company's mine projects.
Price to Earnings Ratio
The price to earnings (P/E) ratio, the ratio of market price per share to earnings per share (EPS), provides an alternative measure. It is more of a relative valuation as opposed to the intrinsic valuation sought through DCF analysis.
The P/E ratio is most often used to compare companies engaged in the same business. When considering companies in the mining industry, such comparisons need to be further refined based on company specifics, such as the interest rates companies have to pay for financing, the countries where a company primarily operates and expected growth rates. These more market-specific factors must be included to insure that P/E comparisons are being made between genuinely similar companies.
The economic cycles of commodity prices that mining companies are subject to has led to a theory that investors should buy a mining company's stock when it has a high P/E ratio caused by lower earnings, and sell the stock when it has a low P/E ratio, the result of higher earnings. However, this theory fails to account for market anticipation of cyclical turns, which often leads to a peak in share price that occurs before the actual low of a company's P/E ratio.
Enterprise Value to EBITDA Ratio
A less common metric sometimes applied to mining companies is the enterprise value to EBITDA multiple. This measure examines the total market value of a company as a multiple of its operating profit, or earnings before interest, taxes, depreciation and amortization ratio (EBITDA). It is more typically applied when evaluating a company for purchase rather than for equity investing purposes. Nonetheless, this metric can be useful in equity valuation of mining companies because efficient management of costs is especially crucial to the success of companies in the mining industry.