You might say that any form of valuation analysis is imprecise and at best directional. Many other factors go into the decision-making process. The real issue is the mining financial sector’s reluctance to adopt advanced methods.
There’s too much “black box” thinking.
The mining industry has long leaned on Net Present Value (NPV) for investment decisions. This practice took root in the 1960s, boosted by modern portfolio theory and growing computing power. NPV’s simplicity makes it a go-to tool—easy to learn, and quick to apply.
But simplicity can be misleading. NPV calculates value by discounting future cash flows to their present value using a constant rate. This method assumes all cash flows and projects carry the same level of risk. In reality, risks vary greatly. Fixed royalty receipts are more certain and valuable than fluctuating equity payments.
Future capital costs are riskier than variable operating costs. Commodity prices, too, don’t increase in a straight line over time. This flawed risk assumption leads to several issues. High-cost assets get overvalued. Long-term projects are undervalued due to overstated risks. Infrastructure investments are mispriced. M&A risks are understated, leading to overvaluations.
Ultimately, it all results in poor investment decisions. More accurate valuation methods exist. Real Options (RO) and Risk-Adjusted Discounted Cash Flow (RDCF), modern asset pricing (MAP). These methods adjust cash flows for their risks and discount them at a risk-free rate, giving a clearer value. Despite their benefits, they are rarely used due to their complexity.
Moving beyond NPV is key for better investment decisions.
Author: Phil O’Connell
