Wednesday, November 2, 2011

Value or Not?

Analyst Barry Cooper believes Barrick Gold (ABX), a gold miner, is a value stock. He cites the stock's P/E ratio, which is under 10, and argues that "value investors will either step into the stock or there are no value investors left in the market". But intelligent investing is not just about isolating low multiples; for this reason, Cooper is wrong about his assertion on so many levels.

For one thing, earnings estimates are only as good as the assumptions underlying them. In Cooper's estimates of Barrick, a whopper of an assumption is that the price of gold will remain at $1750/oz. Of course, it's possible that the price of gold will stay at or even rise above $1750/oz, but it may be just as likely that it will fall considerably. Over the last few hundred years, the price of gold was at the $1750/oz level in just one of those years - this one! Though many readers of this blog believe we are in a new era for gold, ten years ago the price of gold was just $300/oz...do you really think it can't happen again? What would the current P/E be worth then?

Another issue here is leverage. Focusing on a P/E number tells you nothing about risk due to leverage. With its $10.5 billion of net debt, Barrick has an enterprise value of about $60 billion. This gives it an EV/EBIT ratio of about 8 (even at the current price of gold!) which is nothing spectacular. Considering how sensitive that EBIT is to the price of gold, that ratio could change very quickly.

Finally, if you're going to base an analysis on the P/E ratio, you should at least look at its oft-forgotten cousin, the P/B ratio. Barrick trades at almost 2.5x book value, suggesting there will be a lot of businesses (other miners) expanding to take advantage of the profits that are out there. But Barrick has no monopoly here; this is a commodity product, and therefore competitors are free to compete by driving up the cost of land/labour/supplies and increasing the supply of gold on the market. All of these are bad for Barrick, especially if there is an inherent expectation (like there was during the housing bubble) that prices can only go up. Barrick is already seeing this competitive pressure, as "costs are rising amid inflationary pressures in the industry".

On average, low P/E stocks will outperform the market. But not all of them! An understanding of risk is essential to avoid getting taken by Mr. Market.

What's your take on this stock, value or not?

Disclosure: No position

This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please consider subscribing to the feed.

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