A Novel Way To Value Silver Wheaton

| About: Silver Wheaton (SLW)

Silver Wheaton (NYSE:SLW) operates such a unique business model that it apparently makes the company difficult to value, as evidenced by what I believe to be a drastic disconnect between its current share price and the price of silver. It seems to be proving tricky to determine how much you should pay for a piece of what I believe may be the best business model in the world, providing what is essentially venture capital funding to gold mining companies that later allows them to buy silver byproducts for $4 and sell it at the spot price.

Obviously, this business model is quite profitable at current market prices, and many sophisticated methods have been used on this site to try to translate this powerful silver streaming strategy into the intrinsic value of the company, ranging from discounted cash flow analysis to a portfolio of European call options. However, no matter how well thought out and insightful the analysis may be, their bullish message is often veiled by complexity. And since it is always better to be approximately right rather than precisely wrong, I would like to put forward a much simpler thought experiment to show that SLW is undervalued, at least with respect to physical silver.

A buyer of silver bullion would be expected to believe that the price will rise due to the greater fool theory. Relax, gold bugs, I'm not joining the Buffett/Munger tag team attack on these "non-productive" assets, I was referring more to the eternally fiscally clueless government and by extension the overcompensating Federal Reserve. Given these stimuli (pun intended), someone buying silver for about $25/ounce today might be expected to hope to be able to sell it in ten years for $50, a 100% return, or 7.2% annualized. Not bad, until you consider that for the same $25, you could buy a share of SLW, and the company would buy roughly a tenth of a ounce of silver per year for $4 and sell it on your behalf.

At the end of ten years, SLW would have bought over an ounce of silver for $4 and sold it at an average price of $37.50, assuming the price increased steadily to $50. This would give you profits of even more than buying and selling the ounce of silver yourself, and you'd still own the shares, having also collected dividends along the way! And this estimation doesn't even take into account that SLW is actually growing silver production with little additional investment, due to the fact that many of its purchase agreements are over the life of mines that are actually increasing production.

To refine our back of the envelope calculation above, we can consider that SLW produced almost 25M silver equivalent ounces last year, or roughly 0.07 ounces per share since there are about 350M shares outstanding. Production is expected to increase steadily to about 27M ounces this year and to 43M ounces in 2016, or roughly 0.08, 0.09, 0.1, 0.11, and 0.12 ounces per share in the years 2012-2016, respectively. Extrapolating this out for the next 10 years, this would add up to about 1.25 ounces that could be sold for an average profit of over $30, much better than you could possibly hope to do by buying and selling silver yourself.

This demonstrates that SLW is indeed levered to the price of silver, but it's strictly good leverage, the kind that doesn't blow up if the price goes down. If you bought an ounce of silver yourself and the price goes down, there's no way you can make money unless you're a good silversmith. However, SLW would still be profitable even if silver declines substantially, and while the stock would probably take a bigger hit than justified in this case, the silver streaming model would continue cranking out profits. Even if silver went down to $10/ounce, the company still would have sold the same 1.25 ounces per share referenced above for a profit of about $7.50 per share, certainly preferable to losing twice that if you would have just bought silver bullion.

Hopefully this simplified case study provides fellow or potential investors with a new perspective on the power of Silver Wheaton's outstanding business model. It's not often that you can own a piece of a business that is able to buy a desirable commodity for far cheaper than you possibly could, and even rarer to be able to do so at an actual discount to the commodity itself. Therefore, I don't think it is an opportunity that will last, as I expect SLW to begin trading at a premium to the price of silver, since it offers so much more upside with, almost unbelievably, less downside as well. Who says you can't have your silver and sell it too?

Disclosure: I am long SLW.