Gold prices edged lower yesterday due to a strengthening US dollar. The dollar index, which measures the greenback against a basket of six major currencies, increased by 0.3%. This was bad news for gold miner Newcrest Mining Limited (ASX: NCM). It came after the gold price fell by 4.6% last week.
Newcrest's shares are down 9% in the last five trading sessions. Could they decline to their 2016 starting price of $13?
Gold update
The outlook for gold has become more uncertain in recent days. There is intense speculation that the Federal Reserve will raise interest rates in December. The chances of this happening have increased due to generally positive economic data from the US. Although the jobless rate increased to 5% last week, the overall performance of the manufacturing and services sectors has been strong.
This has caused traders to price in a 70% chance of a rate hike in December. A stronger dollar is bad news for the gold price because it makes the precious metal more expensive to buy for non-US based investors. A higher interest rate also makes interest-producing assets more appealing versus gold.
Members of the Federal Reserve have hinted that rates could rise before the end of the year. For example, the Chicago Federal Reserve President stated yesterday that he 'could be fine' with raising US interest rates in December. Since Newcrest relies on gold production for 85% of its sales, a fall in the price of gold could hurt its financial performance.
Sector peers
After its 58% rise since the start of the year, Newcrest trades on a relatively high valuation. It has a P/E ratio of 29, which is higher than the P/E ratios of sector peers BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO). They have P/E ratios of 13 and 17 respectively. Further, Newcrest has less diversity than BHP Billiton. This increases its risk profile relative to its two sector peers and means it is less deserving of the current valuation premium in my view.
Looking ahead
Newcrest's planned acquisition of a stake in SolGold has the potential to positively catalyse its profitability. Newcrest's free cash flow of US$814 million in financial year 2016 also provides the opportunity for further M&A activity, as well as exploration and asset development over the medium term.
However, in my view Newcrest's shares will move in line with the gold price. It could endure further falls over the short term since a US interest rate rise before the end of the year is more likely than not. But I doubt that Newcrest will slump back to its 2016 starting price of $13. It may be overvalued relative to peers, but demand for gold should remain relatively high in the medium term. That's because only one interest rate rise is forecast for the next year. This will lead to a modest fall in Newcrest's share price rather than a crash in my opinion.
