Ask Colin

What PE ratio and Dividend Yield would represent a margin of safety in Resources stocks?

It is my view that price earnings (PE) multiples and dividend yields are not a good way to value resources stocks.

In simple terms, in an industrial company, there is an implicit assumption that the earnings can be maintained into the future. The whole focus of security analysis fundamental analysis) is to calculate the maintainable earnings of an industrial company. Because it makes things or supplies services to meet an ongoing need and it is assumed that the profit is maintainable almost indefinitely. This makes use of a heuristic (rule of thumb) like PE multiple or dividend yield a valid way to get a measure of relative value and hence the margin of safety.

However, resources companies are quite different. In general terms, they are exploiting a wasting asset. Also, demand for most resources tends to be very cyclical. This means that there is not a level of earnings that we can confidently expect to extend into the future almost infinitely like an industrial company. It is more appropriate with a resources company to forecast not the maintainable earnings, but the future cash flow, earnings or dividend streams. To arrive at a present value, we would then discount that cash flow, earnings or dividend streams. This is quite a different proposition.

Put it this way: If you buy an industrial company for 10 times earnings, you can expect to get your money back in earnings in ten years. However, if a resources company is mining a deposit which will be exhausted in three years, paying ten times earnings for it might be speculative to say the least. Of course, it may find more deposits or lots of other things, but ... There are many more "ifs" and "buts" that make the task far more difficult and speculative.