Published: November 16, 2010

Gold and gold stocks have been the rage lately, as the price of gold reaches new highs. However, not all gold stocks are the same. Some have vast reserves of proven gold in the ground. Others have lower productions costs that give them an edge. Using three of the best major gold mining companies as a guide, let's explore how these factors can guide your selection of the best gold stock to own.

Proven and probable reserves
Like treasure hunters, gold miners know there is gold somewhere. The proven and probable number of ounces of gold in the ground is the company's treasure -- only they know where it is.

"Proven" means they know how many ounces of gold are in the ground for sure. "Probable" indicates there is a statistical probability there are so many ounces in the ground. Geologists use standard procedures to derive the probable number of ounces.

The more ounces of gold that a company has in its proven and probable column, the more it should be worth. Updated annually, in 2009, Barrick Gold Corporation (NYSE: ABX) had 139,751,000 ounces of proven and probable gold in the ground, substantially more than Newmont Mining Corporation (NYSE: NEM), with 91,800,000 ounces and Goldcorp (NYSE: GG), with 48,470,000. With so much more gold in the ground, Barrick should be more valuable to investors.

If we take the enterprise value of the company, which represent's the company's value if it were to be acquired, divided by the number of proven and probable ounces in reserve, we can identify how the market values an ounce of the company's gold in the ground, known as Enterprise Value / Reserve Ounce (EVO). At the end of 2009, Goldcorp's reserves were valued at $63.18 per ounce, while Barrick's were less than half that number at $31.58, with Newmont achieving the lowest valuation at $27.39.

From this, you could imply that Newmont is the best opportunity, since the market places the lowest value on the gold it has in the ground.

But what about the cost to mine that gold?

Low cost producer
Remember, the market sets the price for gold -- not the mining companies. The companies that produce their gold at the lowest cost per ounce make more money.

Mining for gold is a capital, labor and energy-intensive business. According to the GFMS, a precious metals consultancy based in London, the average cost to produce an ounce of gold has risen above $500.

Most gold mines extract other metals and minerals found when they mine for gold. Copper and silver are the most common. According to the Gold Institute Production Cost Standard, the best way to measure what it costs for a company to produce an ounce of gold is to subtract out the price received from the sale of other metals, known in the industry as the Cash Cost (by-product).

For the trailing 12 months ending in September 2010, Goldcorp leads the way, with by-product costs of $317 an ounce, well below the average cost and that of its large competitors. This price is up from $295 for the 12 months ending in December 2009.

Barrick has a slightly higher cost per ounce of $346, down from $363 for all of 2009, on the strength of its copper production. Subtracting the sale of copper from the gold helps to lower production costs.

Newmont realized a cost of $478 an ounce, down from $526 an ounce for 2009. Newmont is benefiting from a rather large amount of copper by-product in its reserves. As copper prices expand with the economy, it will have a greater influence on a number of gold miners.

In this case, Goldcorp is the clear winner, with Barrick coming in second. Newmont will see its by-product cost for gold fall as it reaps the rewards of higher copper prices.

Valuing gold companies
As we have seen, the market value of a gold company's reserve varies significantly. Without going into detail, this depends largely on the cost to extract the gold from the ground. It also varies with the value investors place on other metals the company might have in reserve and produce. Putting these together gives us a simple way to compare gold mining companies.

The plot below shows the Enterprise Value / Reserve Ounce (EVO) vs. the Cash Cost to Produce (by-product) gold.

Investors want to see a gold company move from the upper left part of this graph down and to the lower right. When this happens, it means the value of the enterprise goes up along with the miner's stock price.

Goldcorp wins on both dimensions, though it might not have much more room to improve. [Nathan Slaughter, Chief Strategist of our Market Advisor newsletter, turned his readers on to Goldcorp just in time. Now, they're sitting on a +58% gain.] The market places lower value on Barrick's gold reserves, possibly indicating that its gold reserves are not as high-quality.

Newmont is even more interesting. Should the price of copper rise faster than the price of gold, it will drive down Newmont's "cash to produce price" to the level of Barrick and Goldcorp, thanks to its large copper reserves. Newmont has more gold reserves in the ground than Goldcorp, so we might see its EVO raise as the market places a greater value on the total enterprise.

Action to Take --> Don't buy gold stocks simply due to the rising price of the metal. Buy them for their proven reserves and production costs to mine and refine an ounce of gold, especially if these two factors will get better in the coming quarters.

As long as overall confidence in the economy remains in the doldrums, the price of gold will remain in its uptrend.

Up to now, Goldcorp has been the best gold stock to own. But going forward, Newmont has the best prospects for investors as the company climbs the valuation curve with its large holdings of gold and copper.

-- Hans Wagner
Contributor
StreetAuthority