Discounted cash flow is a valuation method that estimates the value of an investment based on its expected future cash flows. By using a DCF calculation, investors can estimate the profit they could make with an investment (adjusted for the time value of money).
The discounted cash flow (DCF) is a common and widely used technique in business valuation, including mining due to its simplicity. It is also easily understood by stakeholders. The DCF is quite simple, valuing the future expected cash flow into the present time by using specific discount rate [1].
To evaluate a mining project using discounted cash flows (DCF), you generally follow these steps:
Cash flow projection: estimate the future net cash flows generated by the mining project over its expected life. This includes revenues from mineral sales minus operating costs, capital expenditures, taxes, and any other costs. Accurately forecasting production, ore grade, and prices is essential for reliable cash flow projection.
Discount rate selection: choose an appropriate discount rate to account for the time value of money and riskiness of the project. The discount rate is higher for higher-risk projects. In mining, the discount rate often reflects both project-specific risks and the cost of capital (e.g., Weighted Average Cost of Capital – WACC).
Discount cash flows: calculate the present value (PV) of each future cash flow by discounting it back to the present using the discount rate:
PV = CFt × (1+r)-t
where CFt is the cash flow at time t and r is the discount rate.
Net Present Value (NPV): sum all the discounted cash flows, including initial capital investment (usually a negative cash flow at time zero). The NPV is the difference between the present value of inflows and outflows. A positive NPV suggests the project is economically viable.
Internal Rate of Return (IRR): Calculate the discount rate that makes the NPV zero. IRR helps assess the profitability by comparing it to a minimum required rate of return.
Interpretation and sensitivity analysis: Evaluate project viability by the NPV and IRR results. Conduct sensitivity analysis on key variables like metal prices, production costs, reserve size, and discount rates because these can significantly affect results.
The DCF method explicitly accounts for the risk and the time value of money and is widely used in the mining industry for project evaluation. It requires reliable input data and experience in estimating parameters such as cash flows and discount rates. Managerial flexibility, risk, and uncertainties may also be incorporated using advanced techniques like decision trees and Monte Carlo simulations, but the core of valuation remains the DCF model.
Reference
[1] A. Ardian and M. Kumral, “Dynamic discount rate through Ornstein-Uhlenbeck process for mining project valuation,” IOP Conf. Ser.: Earth Environ. Sci., vol. 212, p. 012058, Dec. 2018, doi: 10.1088/1755-1315/212/1/012058.
