Can you value commodity type companies?
Commodity prices… can anyone predict their movements? Driven by supply and demand, and exaggerated by speculation, predicting the price of oil, iron ore, coal, diamonds and titanium is an almost impossible task. \It is however a task that is required if you are planning to buy shares in a mining company. Ruling out mining exploration companies that make no profit, and whose race to a valuation of zero is only retarded by the amount of cash remaining in the bank and measured by a ratio called the cash ‘burn’ rate, we are left with the producers.
For reasons mentioned above, no mining company is easy to value, however some lend themselves to valuations better than others. The best are those that are large, broadly diversified and relatively stable. BHP immediately comes to mind. Born as a silver and lead mine in Broken Hill in 1885, BHP, following the 2001 merger between it and Billiton, is now the world’s largest mining company with operations from Algeria to Tobago and everywhere in between.
But even BHP cannot escape the commodity cycle and this can be seen in the swings in its valuations in the past. BHP’s valuation can be $48 in one year (2008) and $13 the next (2009). This “valuation volatility” is vastly different to JB Hi-Fi, for example, whose value has risen from less than a dollar in 2003 to $20 to $24 today and in a steady ‘staircase’ fashion.
Many of you have asked me for a valuation for BHP. Using the earnings estimates of the rated analysts on the company, there is clearly some optimism about BHP’s prospects. Returns on equity are expected to rise from 17.5% this year to 24% next year, and circa 28% in 2011 and 2012. These numbers however are still lower than the rates of return the company generated between 2005 and 2007. The estimate I come up with for BHP using the actual estimates of the rated analysts is a value of A$36.56, and if the analysts are right, the value rises dramatically in future years.
Warren Buffett doesn’t like businesses that are price takers – commodity type businesses. The reason is that it is impossible to forecast future rates of return on equity with any confidence. BHP reflects this historically. BHP is big enough now that in some cases it is calling the (price) shots, but don’t forget we are talking about capital-intensive businesses.
Posted by Roger Montgomery, 23 December 2009
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