How to Value an NSR: Calculating Fair Market Value for a Net Smelter Return (NSR) or Net Profit Interest (NPI) Mining Royalty
While a diamond may be forever, a royalty on a diamond mine is not. Gold, silver, precious stones and base metals are all mining assets which may be subject to an underlying royalty structure or multiple royalties. Outside of metal stream financing arrangements, the most common royalty structures would be NSRs (net smelter returns) and NPIs (net profit interests). As the life of a royalty structure is not infinite, the need to properly account for a royalty asset both on the balance sheet and its' fair market value is a necessary calculation for royalty holders to make on a regular basis.
The fundamental tool for valuing either an NSR or NPI is the mechanism of net present value. One needs to calculate the present value (at an appropriate discount rate) of all future cash flows originating from a given mining royalty. (To learn how to do a net present value calculation visit click here).
There are three critical elements in a net present value calculation concerning royalties that warrant discussion. The first important factor is the discount rate. The discount rate will vary with inflation rates and the risk of the asset. For North American mines, a 10% to 12% discount rate is typically deployed in royalty value calculations. However, the royalty discount rate can escalate dramatically if there is a high degree of volatility in the underlying commodity represented by the royalty. For example, base metals such as copper or zinc where there might be a corresponding copper royalty or zinc royalty may require a higher discount rate to accommodate for commodity price volatility. Capital markets typically ascribe copper mining companies a lower price to cash flow multiple than say gold mining companies and that valuation difference should properly be reflected in the valuation of same-commodity royalties. After all, a copper royalty investor does not want to disproportionately pay more than they would have to pay to acquire equity in a producing copper operation. In addition, a higher discount rate is also appropriate where assets are in politically volatile jurisdictions. In some international circumstances, it is appropriate to assign a substantial discount rate given uncertainty concerning the collection of future royalty revenue.
The second vital aspect of calculating the fair market value of a precious metals or base metals royalty is the amount of revenue that the royalty will generate. Foremost, this number is dominated by the expected precious metal or base metal output covered by the royalty combined by expected commodity prices. For output, the initial sum will at first be a function of the % of the NSR or NPI. For example, is the NSR a 1% NSR or a 2% NSR? Pay attention though, this calculation is more than just multiplying a set percentage against the reserves disclosed in the feasibility/technical report as the royalty may cover only a certain percentage of the claims overlaying the deposit. The proper calculation of a royalty requires knowledge as to what percentage of the deposit is ultimately covered by a royalty and what amount of the metal output or profit stream is then subjected to that royalty.
Once one knows how much metal content is subject to an NSR royalty or an NPI royalty, the royalty holder needs to fairly assess the underlying commodity price. This is often a stumbling block between royalty sellers and royalty buyers. A royalty seller is asking a royalty buyer to carry the burden of commodity price fluctuations during the post-purchase period of ownership. Royalties holders that use a spot price to determine future cash flows often significantly over estimate the total revenue that will be generated by a royalty. Those looking to sell a royalty should be prepared for a buyer that wants to generate a reasonable rate of return. A buyer of royalty will want to build in commodity prices using historical averages, not just an assumption that a recent 20-year high in a commodity price will continue for the duration of the royalty's life span. All parties should be realistic here. Some royalty buyers will use futures markets to assess long-term commodity prices but a common mechanism is to resort to the economic feasibility studies associated with the mine with which the NSR or NPI royalty is associated. Those commodity forecasts are a fair mechanism to assess commodity prices because the feasibility study acts as a market assessment of what generated the production decision. If commodity prices fall substantially below feasibility prices, a mine may be closed resulting in no further production and no further royalties. Royalty commodity price decks that parallel feasibility studies also have the added benefit of matching the risk and reward level of investors in both the purchased royalty and the equity of the mine operator. Specific to gold, many gold mine feasibility reports are based on say $900-1000 gold (well above historic averages) but below spot prices of say $1300 or $1400. In this way, selling royalty holders benefit by getting more than historic average prices worked into the royalty purchase price and buyers might benefit from any sustained periods of commodity prices above that average. Royalty owners that expect a royalty company to pay the spot price combined by the duration of the royalty life are unlikely to find a buyer as there is no economic upside or incentive left in the asset for a buyer.
The final element to determine the fair market value of a net smelter return or net profit interest royalty is one of timing. Most obviously, one needs to know how many years the cash flow stream from a royalty is likely to continue. At some point, the mine will be depleted and there will be no further royalty payments. For example, are there three years of mining resources left or seven years? Are those resources produced equally or time or lumpy and back-end weighted? A royalty company needs to earn back its original capital plus a reasonable rate of return over the life of the remaining royalty. Keep in mind that because of the time value of money, long-life mines will necessarily have minimal present value associated with cash flow from a substantial number of years in the future. For instance, a dollar earned in 2025 is worth much less today than a dollar earned in 2015. This is reasonable as royalty revenue from a mine many years out is subject to many risks and investor capital will have necessarily been tied up for an extended period of time. Practically-speaking, the majority of a royalty's value is determined by royalty revenue in the near to mid-term which is why selling a royalty during a period of commodity strength makes significant economic sense for a seller.
Some mining royalties, both precious metals royalties and base metals royalties, offer life of mine revenue. Others may cover only portions of a mine that offer no exploration upside or become only applicable above certain commodity prices, both of these having less value. If exploration success occurs, royalty streams continue further into the future than first estimated. This too is an often stumbling block of determining fair market value for a mining royalty. Realistically, there is no certainty of exploration success and therefore there can be no certainty that the lifespan of a royalty expands. Asking a royalty company to have good faith that a resource will expand is not a functional position that a royalty company, private or public, can burden their investors with. Where the parties express some mutual confidence in the resource expanding and the life of mine expanding, there still remains the commodity risk associating a potential future slow-down in prices and the discount associated with brining that revenue forward by perhaps a decade or more. Ultimately, to reach fair market value, royalty sellers should considerably reduce expectations surrounding price gains from reserves not otherwise booked in M&I at the time of sale.
As it concerns net profit interest royalties, these royalties require extensive due diligence in order to determine the likely free cash flow. In a net profit interest royalty, certain operating expenses must first be paid. As such, one should look closely at the terms of the royalty to gain an appropriate understanding as to what the free cash flow (or profit) from a given mining operation is likely to be. Underestimating expenses or failing to include a cost otherwise deducted before profits on royalty can have a dramatic impact on the calculation of a net present value.
Ultimately, royalty companies, like all mining companies, have their assets valued based upon the future cash flows that they can produce. Consequently, existing NSR royalty holders and NPI royalty holders need to adopt common valuation metrics and techniques in order to generate a royalty value that is reasonable in the context of a marketplace. If a royalty is valued at $10 million using these metrics, an existing holder can always re-allocate that capital to mining equities or earlier-stage royalties thus keeping exploration and cash flow exposure to a given investment theme, e.g. gold, silver or copper. In this regard, the fair market valuation of royalties will reflect, to some extent, the valuation of the mining company operating the mine to which the NSR applies.
Gold Royalties Corporation works extensively with mining companies and prospectors to assist them in monetizing royalties and can assist with the fair market determination of royalty values involving gold, silver, platinum, palladium, copper, zinc, lead and many other metals.
About the Author:
Ryan Kalt is the CEO of Gold Royalties Corporation.