Real Options Valuation of Australian Gold Mines and Mining Companies

Abstract

Conventional discounted cash flow valuation techniques are inappropriate for mining companies because operational flexibilities are deemed an essential component of mine values. In this article the authors review the real options literature on the valuation of mines and their embedded option to close the mine. They use a model based on Brennan and Schwartz (1985) to empirically value Australian gold mines and mining companies. One difficulty with doing empirical research in this area is in obtaining relevant and complete data, given the nature of real assets and the fact that investments are typically private in nature. The mine data for this study is supplied by Brook Hunt Mining and Metal Industry Consultants, UK and covers the period from 1992 to 1995. The primary advantage of this data set is its consistency across different mines that cannot be matched by data sets derived from annual reports data. The authors find that the real options model is a useful tool for the description and valuation of operational flexibilities. However, the values of the embedded options are very sensitive to estimation errors in the input parameters of the model. While average and median closure option values are economically significant, the option values vary over a large range.