Last week a colleague complained to Strictly Boardroom that equity analysts should be locked up – or at least held more accountable for getting their valuations so horribly wrong.

Without naming the specific investment bank that he was referring to, the email dialogue went something like this:

“A year ago these guys have a ‘buy’ on the same stock valuing the company at around $2 with the share price not far below that level. A year previously they were saying ‘buy’ at $2.50 per share. Now they are advising a ‘sell’ at 50c – how can that be? These guys should have long since lost their jobs.”

My colleague’s experience of following equity recommendations would not be uncommon – and I suspect if there was a systematic study of recommendations across the emerging companies in the resources sector over the last two years it would reveal the example above to be more the norm rather than an outlier, so the numbers did not surprise me.

Why are analysts so often wrong then – and why your scribe’s lack of surprise at the seemingly systemic valuation error?

The answer all lies in the numbers – and critically of course, in the various assumptions therein.

In the general case most analysts (at least for producing or near-production assets) will do a net present value per share calculation using a sum-of-the-parts approach.

So say a gold company has a project with an NPV of $100 million (on a 2012 gold price assumption of $A1600 per ounce) and an even 100 million shares then the NPV calculation would spit out a $1 per share initial discounted cash flow value.

Next the fudge factors are added. These relate, among other things, to how analysts measure the value of early exploration properties and joint ventures.

In a hot market, exploration properties will attract premium (unsubstantiated) fudge factors, so say in the simple case above that $20 million of extra value is attributed to exploration properties.

So let's say the share price a year ago was 80c – the analysts say NPV of the mine is $100 million and exploration of $20 million, then their target price would be $1.20 against 80c trading value and a $100 million “visible NPV” (by DCF) at an $1600/oz flat gold price assumption.

Analyst would say ‘buy’

Fast-forward a year: such a company's price would likely now be 30c (perhaps less).

The NPV at $1350/oz of future production, now nearing break-even, may only be $30 million.

The company will have used up a year of reserves between drinks – and now faces lower flat gold price assumption from the analysts.

Indeed, to argue that they are prudent, the analysts may now choose to use $1250/oz to value the mine’s cash flows, which are consequently deemed marginal.

The fudge factors would have changed too, of course – with a view that exploration is a 2013 liability more than a 2012 asset.

So exploration is now valued at zero, or even a negative figure (so as to account for tenement maintenance exploration that is required but attracts no revenue).

A particularly conservative equity analyst may now also “remember” corporate costs – a further negative of perhaps $1-2 million per year.

Given the above it becomes easy to see how one could easily reach the situation where the analyst would say ‘sell’ at 30c versus ‘buy’ a year ago at 80c.

Both pieces of analysis are short-sighted – but both work perfectly well on any spreadsheet.

So are they both wrong? Yes, of course they are.

Can the analyst justify why they are so wrong? The obvious excuse is that the facts have changed – and they have – but a good analyst would have tried to capture that likelihood in the first instance.

Some 20 years ago, it became possible to model mines on a full commodity cycle basis – although back then using a steam-driven computer that needed a suitcase to carry it around.

Now it is far easier of course.

Full commodity cycle valuation would have corrected both the overshoot errors in the simplified valuation examples described above (the first valuation being too high, the second too low).

Done correctly, full price cycle modelling does not just give you an impossibly wide range of possible future outcomes (which it will do if done wrongly) – but can make clear the valuation outcomes that are likely based upon where you currently sit in the commodity price cycle.

Perhaps one day full commodity price cycle valuation will become the norm rather than the exception (if the chorus of disquiet over incorrect valuations grows) – but for now we seem stuck with the equity valuation methods described above: analysis that will always be wrong.

Good hunting.

Allan Trench is a professor at Curtin Graduate School of Business and research professor (value and risk) at the Centre for Exploration Targeting, University of Western Australia, a non-executive director of several resource sector companies and the Perth representative for CRU Strategies, a division of independent metals and mining advisory CRU Group (allan.trench@crugroup.com).