Focus on Gold Miners’ Cash Flow—Not Earnings
21 August 2023
Read Time 4 MIN
Gold ends July higher; we believe free cash flow generation, not earnings, is a better way to assess the value and investment appeal of a gold mining company.
Gold steadies on mixed economic outlook
Economic data releases in July fueled expectations that the U.S. Federal Reserve (Fed) is nearing the end of its hiking cycle, supporting gold prices which were up 2.4% during the month, and putting pressure on the U.S. dollar (down 1.03%, as measured by the U.S. Dollar Index (DXY1)). Gold climbed back above $1,950 per ounce on 12 July, following the release of June U.S. Consumer Price Index2 figures showing a 3% year-on-year increase, compared to 4% in May. Gold advanced further, reaching a monthly high of $1,978.72 on 18 July, as U.S. retail sales for June came in below expectations. The yellow metal held on to most of its gains as the markets digested another interest rate hike by the Fed on 26 July, and a 3% yearly increase in the June U.S. Personal Consumption Expenditures Price Index3 (the Fed’s preferred inflation gauge). Gold closed at $1,965.09 on 31 July.
NYSE Arca Gold Miners Index (GDMNTR)4 and MVIS Global Juniors Gold Miners Index (MVGDXJTR)5 outperformed gold, up 4.54% and 5.86% respectively, during the month. Q2 2023 financial and operating results for the gold sector have been mixed. Many of the producers had flagged a weaker first half of the year, and most of them have maintained their full year 2023 guidance. Thus, we can reasonably expect an improvement in the second half of 2023, although there is no guarantee of such an evolution. The market is very focused on companies meeting expectations, so any significant misses are likely to lead to poor share price performance.
Why forecasting earnings for gold miners is hard
While we agree that companies must meet their guided targets to gain market confidence in their ability to deliver consistent results, we also understand the unique challenges of the mining industry. As long-term investors looking for value creation, we are less obsessed with quarterly earnings and much more focused on companies’ outlook for free cash flow generation over the next 10 to 20 years. From decades of experience covering this sector, including sell-side experience which entailed issuing earnings-per-share (EPS) estimates every quarter for all companies under coverage, we can comfortably say it is nearly impossible to forecast a precious metals company’s earnings for any given quarter. The challenges come from different sources, most relevantly:
- The fact that these companies are issuing forecasts based on only estimates of the properties of the gold deposits they are mining. Clearly, we expect that these estimates are a good representation of the gold deposit over the life of the mine. Quarter-over-quarter, it is also very reasonable to expect variations from those estimates that could certainly impact earnings, while generally having no material impact in the net asset value of the mine or the company.
- Companies issue full-year guidance which tries to account for quarter-to-quarter fluctuations, but analysts must issue quarterly guidance that cannot predict these variations. It is these quarterly estimates that the markets gauge companies against.
- Earnings are based on complex accounting and reporting standards, including one-off and non-cash items, that make it very difficult to reconcile reported earnings to estimates.
- Other factors, including the variations in the realized price of gold and other produced metals. While analysts may be able to account for spot price fluctuations during the quarter, predicting the timing of sales and the impact of provisionally priced sales (which later need to be adjusted) is nearly impossible.
Focusing on the longer-term
In our view, focusing on free cash flow generation not just over the current quarter but over the long term, is a much better way to assess the value and investment appeal of a gold mining company. In fact, our internal models generate an in-house metric which we created to capture our approach. We refer to it as “free cash flow per ounce”, and it is the total, undiscounted free cash flow the company generates over its operating horizon, divided by all the gold (or gold equivalent) ounces we estimate it will mine during that period. It is a simple, yet transparent measure that allows us to assess the relative valuations of the companies in our universe.
Enterprise Value/oz vs. Free-Cash-Flow/oz
Source: VanEck. For illustrative purposes only. Enterprise value (EV) per ounce (EV/oz) is the ratio of a company's enterprise value vs the total amount of mineral resources in the ground. FCF = Free-Cash-Flow.
During earning season, EPS headlines move stock prices.. However we believe gold equity investors should demand that companies deliver against their operational targets, while focusing less on quarterly earnings and more on the outlook for good old free cash over the next decade or two. It is also helpful to remember that any gold not mined (or sold) this quarter is not lost, it will still be there the next quarter or year, ready to meet the world’s historical need for the shiny metal, potentially at even higher prices.
When assessing an investment in gold, investors should keep in mind the main risk factors associated with such an investment. They comprise, among others, the risk of investing in the basic materials sector, the risk of investing in gold and silver mining companies, risk of investing in smaller companies as well as the more general market risk.
1 The U.S. Dollar Index (DXY) measures the value of the U.S. dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies.
2 The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
3 U.S. Personal Consumption Expenditures Price Index (PCE) is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services.
4 NYSE Arca Gold Miners Index is a service mark of ICE Data Indices, LLC or its affiliates (“ICE Data”) and has been licensed for use by VanEck UCITS ETF plc. (the “Fund”) in connection with VanEck Gold Miners UCITS ETF (the “Sub-Fund”). Neither the Fund nor the Sub-Fund is sponsored, endorsed, sold or promoted by ICE Data. ICE Data makes no representations or warranties regarding the Fund or the Sub-Fund or the ability of the NYSE Arca Gold Miners Index to track general stock market performance. ICE DATA MAKES NO EXPRESS OR IMPLIED WARRANTIES, AND HEREBY EXPRESSLY DISCLAIMS ALL WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE WITH RESPECT TO THE NYSE ARCA GOLD MINERS INDEX OR ANY DATA INCLUDED THEREIN. IN NO EVENT SHALL ICE DATA HAVE ANY LIABILITY FOR ANY SPECIAL, PUNITIVE, INDIRECT, OR CONSEQUENTIAL DAMAGES (INCLUDING LOST PROFITS), EVEN IF NOTIFIED OF THE POSSIBILITY OF SUCH DAMAGES. ICE Data Indices, LLC and its affiliates (“ICE Data”) indices and related information, the name "ICE Data", and related trademarks, are intellectual property licensed from ICE Data, and may not be copied, used, or distributed without ICE Data's prior written approval. The Fund have not been passed on as to its legality or suitability, and is not regulated, issued, endorsed, sold, guaranteed, or promoted by ICE Data.
5 MVIS®️ Global Junior Gold Miners Index is the exclusive property of MarketVector Indexes GmbH (a wholly owned subsidiary of Van Eck Associates Corporation), which has contracted with Solactive AG to maintain and calculate the Index. Solactive AG uses its best efforts to ensure that the Index is calculated correctly. Irrespective of its obligations towards MarketVector Indexes GmbH (“MarketVector”), Solactive AG has no obligation to point out errors in the Index to third parties. The VanEck Junior Gold Miners UCITS ETF is not sponsored, endorsed, sold or promoted by MarketVector and MarketVector makes no representation regarding the advisability of investing in the Fund.
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