Last month I published a Buffett influenced qualitative checklist on Silver Wheaton (SLW) and showed how strong SLW is thanks to a sound business plan, capable management, significant earning capacity and solid debt management. That article can be found here.
However, Buffett is a true value investor and never makes an investment solely on qualitative characteristics. Some of Buffett’s valuation methodology includes three financial ratios - Return on equity (ROE), profit margins (PM) and debt to equity (D/E). Once Buffett proves a company’s basic financial fundamental with these ratios, he then assigns a total intrinsic value for the company and compares this value to its current market cap. Let’s see if SLW checks out on some basic fundamental ratios.
Silver Wheaton’s three-year average return on equity comes in just above 17%. This proves net income is translating into shareholder value. Buffett’s benchmark for ROE is 15% so SLW passes this initial barrier.
With regard to debt Buffett advocates that companies need little debt to have true unleveraged earnings growth. Buffett typically likes companies with a debt to equity ratio less than 80% of its competitors. Silver Wheaton’s current D/E is 14.5% which is considerably less than the industry and the competitors listed below. Silver Wheaton seems to be returning profits shareholders while taking on very little debt.
Company | Ticker | Debt/Equity |
Silver Wheaton | 15% | |
Pan American Silver | 36% | |
Coeur d'Alene Mines | 52% | |
Great Panther Silver | 28% | |
Silvercorp Metals | 25% |
The last ratio to consider is profit margin. Let’s see what percent of revenue turns into pre-taxed net income. SLW’s three-year average pretax profit margin is slightly above 31% a great ratio which is higher than the industry average. What is even more impressive about SLW’s cash generation is its free cash flow as a percent of sales. Last year this ratio was above 43%!
SLW certainly demonstrates basic financial fundamentals. The next step is placing an intrinsic value on the company. Accurately predicting a company’s real value is the hardest task for every investor, even for the oracle of Omaha himself.
The first step in placing a sound valuation on SLW is projecting the future value of silver. For a realistic valuation, the only way to fairly predict the price of silver and also what SLW will sell silver at is to assign probabilities for future Silver prices. These same probabilities will also work as weights for SLW’s total silver production. For example, I have predicted there is a 10% chance that through 2015 SLW’s average sale price of silver will be $30 per ounce of silver. For SLW’s total production there is also a 10% weight on selling silver at $30 per ounce.
After projecting silver prices, we can estimate total future revenue. Management has confidently predicted that by 2015 total silver production will reach 43,000,000 ounces. By multiplying the future silver production by all probabilities/weights we can come up with total 2015 revenue of 1.6 billion. To figure cost of revenue, we multiply the same 43 million ounces of production of silver by an average cost of $5 per ounce of silver. (The company’s average silver costs last year was $4.10) I have also included SG&A and other expenses through 2015 in this total cost of revenue figure. Taking the costs out of revenue we get a total profit of $1,129,000,000 through 2015.
Probability/Weight | Silver Price | Production Silver Ounces | Revenue |
2% | $ 10 | 43,000,000 | $ 8,600,000 |
2% | $ 15 | 43,000,000 | $ 12,900,000 |
5% | $ 20 | 43,000,000 | $ 43,000,000 |
5% | $ 25 | 43,000,000 | $ 53,750,000 |
10% | $ 30 | 43,000,000 | $ 129,000,000 |
20% | $ 35 | 43,000,000 | $ 301,000,000 |
23% | $ 40 | 43,000,000 | $ 395,600,000 |
25% | $ 45 | 43,000,000 | $ 483,750,000 |
8% | $ 50 | 43,000,000 | $ 172,000,000 |
100% | 2015 Revenue | $ 1,599,600,000 | |
Less Cost of Revenue | $ 470,000,000 | ||
Profit | $ 1,129,600,000 |
From applying the same methodology of probabilities and weights towards potential earnings multiples we can get a future 2015 market cap value for Silver Wheaton
Probability | Multiple | Future Value | Market Cap | CAGR |
5% | 10 | $ 11,296,000,000 | $ 564,800,000 | -7% |
10% | 15 | $ 16,944,000,000 | $ 1,694,400,000 | 6% |
25% | 20 | $ 22,592,000,000 | $ 5,648,000,000 | 17% |
30% | 25 | $ 28,240,000,000 | $ 8,472,000,000 | 26% |
30% | 30 | $ 33,888,000,000 | $ 10,166,400,000 | 34% |
100% | 2015 MarketCap | $ 26,545,600,000 | 24% | |
2011 MarketCap | $ 14,080,000,000 |
Using these assumptions SLW’s market at the end of 2015 could exceed $26 billion. This intrinsic value compared to SLW’s current market cap of 14.4 billion represents compounded annual growth rate of 24% and a 2015 SLW share price of $75.
Most of the probabilities and weights figured into this valuation in my opinion are modest. I personally feel there is a strong chance silver trades at an average cost of $45 through 2015. If SLW comes close to its 2015 silver production estimate, trades at its historical multiple of 30x earnings and sells silver at an average cost of $45 through 2015, SLW has a CAGR above 60% and a 2015 share price higher than $150.
Although Buffett would never buy a silver company, the legendary investors look for companies that have a strong intrinsic value which is certainly the case for SLW. After evaluating the qualitative characteristics of Silver Wheaton and also finding an intrinsic value for the company well above its current value, I am confident that Silver Wheaton has the potential to significantly outperform for the next several years.
Disclosure: I am long SLW. I have no plans of selling my position in SLW through 2015.
