The Modern Day Gold Rush

The leverage of earnings because of a bull market in gold stock prices is a reason for investing in gold stocks, even at bubble valuation levels, ie. 25-30x earnings.  It is a principle with some merit, but:

1. How is the leverage of earnings affected by production costs?
   
2. How is the leverage of earnings affected by continuing to trade at valuations of 25-30x earnings as the price of gold goes up?
3. How do production costs change over time.
4. What is the overall value of the company over time as gold is sold off?
   

Which is better?  A high cost producer, or a low cost producer?

Since the leverage of earnings through the bull market is a justification for paying bubble valuation prices, if leverage is affected by costs, how it is affected should be examined.

Say company A has production costs of $100/oz, company B has production costs of $200/oz, company C has production costs of $300/oz, and company D has production costs of $375/oz.  So how does the ratio of the money available for earnings grow?

Gold Price	% Up	Company A (Cost $100/oz)	% Up	Company B (Cost $200/oz)	% Up	Company C (Cost $300/oz)	% Up	Company D (Cost $375/oz)	% Up
$400		$300		$200		$100		$25
$450	13%	$350	17%	$250	25%	$150	50%	$75	200%
$500	25%	$400	33%	$300	50%	$200	100%	$125	400%
$550	38%	$450	50%	$350	75%	$250	150%	$175	600%
$600	50%	$500	67%	$400	100%	$300	200%	$225	800%
$650	63%	$550	83%	$450	125%	$350	250%	$275	1000%
$700	75%	$600	100%	$500	150%	$400	300%	$325	1200%
$750	88%	$650	117%	$550	175%	$450	350%	$375	1400%
$800	100%	$700	133%	$600	200%	$500	400%	$425	1600%

So, what this table is saying is that the leverage of the money available for earnings is much higher for a high cost producer.  So, at the start company A already has a share price reflecting good profitability on gold sales.  Company D wasn't even able to operate prior to the bull market and has a low share price compared to gross sales because of it.

Another way of saying it is that at $400/oz Company A has 12 times as much money for each ounce sold available for earning as company D.  That means for both to have say a 25 times earnings share price, for equal sales, Company A would have had 12 time the market cap as company D, and if they had equal numbers of shares, 12 times the share price.  Because Company A is so much more profitable, at the start of the gold rush it already has a massive premium built into its share price.

More importantly, what it is showing is that the extra money from earnings is far less leveraged for the low cost producer than the high cost producer, assuming they are are both trading on the same valuation principle, gold multiples of 25 times earnings.

So, at the start of the gold rush, say $400/oz, Company A and D would both have 4% earnings per share.  If the share price remains constant, at $550/oz Company A would have 6% earnings, and poor justification for much growth of share price, yet company D would have 28% earning, a huge reason for growth in share price.

Conclusion:  A company with higher production costs will experience more leverage in the growth of earnings through a bull market.

But, just what is the leverage of earnings when gold has increased to say, $600?  Or $800?  And is keeping the bubble valuation of share prices at 25 times earnings because of leverage still a reasonable idea?

Next post the leverage of earnings today.

"Everything has its limit - iron ore cannot be educated into gold."
Mark Twain

"What experience and history teach is this -- that people and governments never have learned anything from history, or acted on principles deduced from it"
Georg Wilhelm Hegel 1770-1831

http://www.zealllc.com/2006/goldvalu2.htm
http://www.zealllc.com/2004/goldvalu.htm
http://www.museumca.org/goldrush/fever19-hy.html
http://en.wikipedia.org/wiki/Gold_rush
http://entertainment.webshots.com/photo/2511039050030579030CNLKGy
http://www.tactical-graphic-design.com/download-clipart-files/saint-patricks-clip-art/clip-art-saint-patricks-jolly-leprechaun-pot-o-gold.gif