An Alternative Approach to Valuation: Silver Wheaton

| About: Silver Wheaton (SLW)

Asset based valuation poses this question: how much would it cost to recreate Silver Wheaton (NYSE:SLW)? At first this seems like a difficult question, but recreating Silver Wheaton doesn't involve meeting with management teams and travelling the world to visit remote mine sites. Silver Wheaton can be easily recreated by purchasing European call options.

A stream is just a portfolio of European call options. A stream allows SLW to purchase a percentage of annual production at a fixed price per ounce. Notice a stream has the same characteristics as a European call option. The upfront payment for the stream is the option premium and the fixed purchase price is the strike price. A 10 year annual stream is just 10 individual European call options, with one option expiring each year. The value of the entire portfolio (stream) is the value of all the individual call options.

Silver Wheaton can be recreated, or replicated, by purchasing a portfolio of European call options. How much would it cost to buy/sell this portfolio? The price of this identical portfolio is the asset value of Silver Wheaton.

Sophisticated option pricing models are controversial, but there are several universally accepted option pricing rules. Using these rules to value streams is inherently conservative because they ignore the time value and insurance value of an option. These rules only provide absolute minimum prices for an option.

Here is the fundamental rule: the value of a call option must be greater than the spot price minus the strike price.

This rule can be used to evaluate how much it would cost to recreate one of Silver Wheaton's streams. For example, replicating SLW's Cozamin stream would require purchasing the following portfolio of European call options:

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(Click to enlarge)

The cash flows from this portfolio are identical to Cozamin's expected cash flows. Therefore, the cost of this portfolio must be the asset value of Silver Wheaton. It would cost at least $382 million to replicate the Cozamin stream with a portfolio of European call options. This means the asset value of Cozamin is $382 million. This exercise is repeated to value the entire firm:

The minimum price of replicating Silver Wheaton with options is $26.994 billion. Silver Wheaton is trading almost 150% below the absolute minimum cost of an identical portfolio of European call options. Penasquito and Pascua-Lama alone are worth SLW's current market cap, meaning investors get the other streams for free at current prices. Silver Wheaton trades as if spot silver is $15.27.

There are superficial reasons to believe this method of valuation can't work for streams. One might object to this method because streams aren't standardized, exchange traded derivatives. It's true that streams have default risk, but all options have default risk. One could argue Goldcorp (NYSE:GG) is better counterparty than many exchanges, like the COMEX. More fundamentally, most options are real options and most derivatives are traded over the counter. Cash flows are the bottom line, and a stream has the same cash flow payoffs as a European call option.

The purpose of asset-based valuation is to determine how much it would cost to reproduce the firm. Asset-based valuation is unpopular because it's impossible to replicate most firms. Streaming companies like Silver Wheaton and Sandstorm Gold (SNDXF.PK) are very easy to replicate. An investor could easily replicate SLW's assets by purchasing a portfolio of call options. It's far easier and less expensive to just buy Silver Wheaton.

Disclosure: I am long SLW.