Gold mining stocks offer leverage to gold as their profits go up more than gold bullion itself. Because of its leverage mining companies offer more upside potential than physical gold. However, picking the right stocks makes all the difference since mining shares are inherently more risky.
Consider that a gold mining company has a production cost of $800/oz to excavate gold and they are selling at the market price of is $1000/oz (to make calculations easy) thus making $200 profit per oz. However, if the price goes up by 10% to $1100/oz and their production cost remains constant the company would increase their profits by as much as 50%.
Gold mining stocks can be very profitable especially during secular bull markets but this asset class is by nature very volatile. Gold mining stocks have different characteristics from general equities and traditional measures such as P/E ratios dont do well in assessing the true value of the company. Other factors such as company cost, production rates, and development trends are more important. Bud Conrad at Casey Research has created a model of how to analyze gold mining stocks based on 8 different factors:
The purpose of Bud Conrads model is to compare the gold reserves in the ground to the stock price to see whether the price is low enough to be attractive. The table below compares the value of different gold mining companies. The far right column shows the valuation ratio. A ratio of 1.0 indicates that a companys stock may be expensive compared to its assets and a value of closer to zero indicates a bargain.
The valuation provides a basic guide line of value but it will change as conditions change. The valuation of certain stocks will change more or less from company to company depending on the change in price of gold and the company stock.
Junior mining companies are characterized as small scale production mine with revenue or an exploration company with no revenue. Exploration companies have more risk because they quickly burn through a lot of cash trying to discover large gold deposits. Senior gold mining companies are less risky as they sit on vast reserves and have developed mines with a steady revenue stream.
However, junior exploration companies are a major source of new supply. They find new attractive land, determine whether a property is economically viable, and bring mines into production. They are critical for finding new discoveries and offer more growth potential.
New discoveries among junior minors have better payoff. For example, consider that a senior mining company with 100 million ounces in reserves and 200 million shares of stock outstanding make a one million ounce discovery. This new discovery would merely increase the companys reserve by 1%. However, the same discovery by a junior miner of 20 million shares outstanding and just 200,000 ounces of proven reserves would increase its reserves by 400%. Therefore junior mining shares offer higher speculative upside if you pick the right stock.
Junior gold mining stocks offer more upside potential but they are also more risky. Unless you are really an expert in the mining industry it is suggested that a portfolio only include about 5-10% of junior mining companies. A safer bet is to add physical gold and senior mining companies.
Here are five factors suggested by Casey Research to consider before buying gold mining companies: