The Silver Wheaton Valuation Method, Part 1: Valuing Impact Silver

Silver Wheaton's (SLW) recent silver stream deal with Aurcana Corporation [AUN.V] provides a significant data point for valuing junior silver producers or near producers. This article describes how to apply this data point in evaluating these juniors. It's written at a level understandable even by "newbie" investors.

The "Value Investing" method of investing in stocks is to invest in companies that are "really" worth significantly more than the value assigned by the stock market. The idea is that eventually (hopefully soon) the market will come to its senses and raise its valuation to something closer to the company's real worth via a stock price rise.

My favorite introduction to this style of investing is Pabrai's "The Dhando Investor". The value assigned by the stock market is the company's market capitalization. Market capitalization (market cap) is easily calculated by multiplying the company's current stock price times the fully diluted number of shares. The fully diluted number of shares can usually be found in the Investor's section of the company's web site.

While it is easy to calculate the market cap, it is not so straight-forward to calculate what the company is "really" worth. The parlance for this is, "valuing the company". There are many ways of valuing companies and these ways vary significantly in their complexity and ease of calculation. When a company is dramatically undervalued, the method of valuing the company need not be extremely accurate. It need only be accurate enough that its error is significantly less than the amount it indicates that the company is undervalued.

This article provides a quick and dirty way of valuing junior silver mining companies. This valuation can be used to identify companies that are dramatically undervalued. It can also be used as an initial filter to determine which companies are worth the effort of a full, detailed examination.

Silver Wheaton is one of the most successful companies in the silver mining industry (see chart below). It doesn't actually mine silver. Instead it buys the silver byproduct from base metal (or sometimes gold) mines. It can do this with win-win deals because the market values silver mine production more highly than base metal mine production. Typically the deal is structured as an up-front payment for the right to buy a fraction of the silver output of a mine at a low cost, for example, $3.90 /oz. Silver Wheaton wins when it sells the silver at market price (currently around 17$/oz giving resulting roughly 13$/oz profit for Silver Wheaton). The actual mining company wins by getting an up front payment plus the $3.90 / oz when the silver byproduct is actually mined. The $3.90 / oz helps lower the cash cost for the mine's primary metal.

The market likes what Silver Wheaton has done and is doing (click to enlarge image):

Silver Wheaton's recent deal with Aurcana Corporation provides a way for valuing producing or near producing silver mining juniors. The deal, in simple terms, is: Silver Wheaton gets 50% of the silver production from Aurcana's La Negra Silver-Copper-Zinc mine. Silver Wheaton pays 25 million$ up front and $3.90 for each such oz delivered. From Aurcana's web site we see that La Negra is expected to produce 820,000 oz/year with a nice long mine life.

So, here's the key data point: Silver Wheaton, who is about the best in the industry, thinks it is quite profitable over the long term to buy a silver mine's production at $61 / annual oz produced. We can use this data point to value junior silver miners and it is very relevant as long as the junior has a cash cost near $3.90 / oz.

Let's use this valuation method to value Silver Wheaton itself. Since Silver Wheaton thought it was a good deal, one would expect that Silver Wheaton is valued more highly than this.

From Silver Wheaton's June 2008 presentation we see:

• Silver Wheaton expect to receive (produce) via its silver stream deals 27 million oz.
• Silver Wheaton has fully diluted 266 million shares for a market cap of 3.862 billion $.

Thus Silver Wheaton is valued at 143$ / annual oz produced. Silver Wheaton (as a major with diversified risk and a low cash cost of $3.90 / oz) is valued quite highly compared to what it just paid for its recent incremental increase in production from the Aurcana deal.

Impact Silver (ISVLF.PK) is an nice little silver mining company with four little producing mines near a company owned mill on a large property in a historic silver mining district in Mexico. The company management seems to have the desirable properties of looking out for the stockholder's interest by avoiding dilution and meeting its commitment (although it doesn't give a lot of future guidance). Having management that looks out for the stock holder is what I find really attractive at first glance.

Impact Silver has 49.8 million fully diluted shares for a market cap of roughly 51 million $. It produced roughly 350 thousand oz of silver in 2007 and seems to have a good plan for doubling that. So, applying the Silver Wheaton Valuation Method, what Impact Silver is "really worth" is 700,000 oz * 61 $/oz or roughly 43 million dollars.

Conclusion

The Silver Wheaton Valuation Method indicates that Impact Silver is fairly valued. This means it's valued for about what Silver Wheaton has shown it would be willing to pay for its expected silver production. As such, it appears to not be a good value investing target.

Comments

[R. Richard ...:]

A very useful piece.

Not exactly the full treatment of Graham, Dodd & Baker of my youth (early '40s); nor of Ben Graham's Intelligent Investor - still a begining point that treats "the Market" as a given (which of course it is not).

I am saving this Part1 for future reference.

2008 Jun 11 08:03 AM

[silverwink:]

Agreed, good article, enjoyed. Now just tell the short-sellers to beware.

2008 Jun 11 08:11 AM

[User 166556:]

interesting twist...very easy to use

2008 Jun 11 08:39 AM

[preachersb:]

Thankyou for showing us that silver wheaton's stock is greatly overvalued. Silver has no purpose. That is why companies sell it for $3.90 an ounce. They can't get rid of it. Silver wheaton's attempt to form a debeers or opec for silver hasn't worked. They cannot sell enough silver to make the whole thing work. That explains why goldcorp sold their 48% stake. NOTE: I do not believe silver wheaton can sell their silver at current spot or futures prices. The market is so thin. Any attempt to sell large quantities of silver would be meet with huge price drops. GOD BLESS Y'ALL!

2008 Jun 11 09:33 AM

[GMiki1:]

Silver is severely undervalued due to the COMEX shorts. See Ted Butler's commentaries. He's waiting for the short squeeze that will send silver to a more reasonable valuation.

Silver has uncountable uses in electronics, among others. Silver is also in shortage. Once silver goes to a more reasonable valuation, this will change the valuation of SLW, a company with little overhead as it has only about three employees. Impact Silver will increase its reserves. Go long and stay long silver. Silver has tremendous potential. However, it's always nice to see that people haven't caught on yet. This prolongs the bull market in the precious metals.

2008 Jun 11 10:30 AM

[Greg Pinelli:]

Down and useless might be a better description...SLWs value is it's net take from ALL it silver streams...and is relative to the ongoing spot silver price. The idea you can look at one deal and get some intelligent fix on SLW or even look so simple mindedly at Aurcana and..without reference to its net return on silver sold....value it is ludicrous.

2008 Jun 11 11:36 AM

[User 41916:]

I find the analysis lacking. How can an evaluation be meaningful without including the assumed mine life of the production??

2008 Jun 11 11:55 AM

[User 30121:]

Talk about pendulum swings. You have the imbicils like preachersb and Georealist, who know NOTHING about PM (that's precious metals for the above mentioned named souls) on one end, and GMiki, who makes sense when he BURPS on the other. All we need is bearfund to chime in to knot the score at 2-2!

2008 Jun 11 02:29 PM

[treefrog:]

what wasn't mentioned about impact silver is that their major stockholder is energold drilling. they have a large realestate holding in an historically very productive mining district.

large,highly prospective realestate holding + they're the stepchild of an exploration machine. connect the dots.

pax
t.f.

2008 Jun 11 03:16 PM

[Tom Szabo:]

I don't think this valuation method works. SLW paid for a stream, not annual production. The price took into account existing resources, potential for new resources, and the mine's ability to reach and maintain certain production rates. These are project-specific factors that cannot be applied to other companies. Note that SLW just paid $80 million for 75% of Farallon's "at least 1 million ounces of silver per year" at Campo Morado. That translates to $106/annual oz. produced. At Augusta's Rosemont project, it is $122/annual oz. produced. That's a 100% range. More importantly, it is wrong to use fully diluted market cap for these types of calculations without considering the "share buyback equivalent". I shouldn't have to explain this to you, but this basically means that you don't treat warrants with an exercise price of $10 per share the same way you would treat $1 warrants. It so happens this isn't much of an issue for Impact Silver, but clearly if we use the $122/oz. number then the company will be seen as moderately undervalued. In conclusion, this valuation method is extremely rough at best and about as useless as in situ metal valuation at worst.

2008 Jun 11 04:43 PM

[oroman:]

SLW pays the USD 3.90/Oz price plus roughly the NPV of the silver stream. This analysis is pretty useless, as noted above by several posters, as it does not consider mine lives for one. As for SLW, the future production numbers they give, are sketchy at best. Expect to be disappointed. And expect further dilution if silver does continue/become "Hot", as they will have to have pay more per oz. (less value), earlier in the development cycle (more risk).

2008 Jun 11 05:23 PM

[Tron:]

oroman

their cost is fixed at $3.90/oz - this doesn't increase. Other than their upfront cost this is their only cost. SLW has the best leverage to the price of Silver out of all the primary Silver miners. Also, they don't get hit by higher diesel costs as their cost/oz is fixed for the life of the stream.

Pretty sweet deal imo... This is why they have the biggest margins in the business. Hopefully the dollar keeps rallying over the summer so I can buy SLW when it gets beaten down to a P/E under 30 as I find it's highly overvalued when compared to the silver juniors at P/E well under 2. Thing is, when Silver does spike next time the big funds will flock to SLW as it's the largest primary silver play and is also very liquid in both CAN and USA with close to 4M shares in each country.

-Tron

2008 Jun 12 02:01 PM

[Tom Szabo:]

Nobody is arguing SLW does not have leverage, they are arguing this particular valuation analysis does not work. It isn't just mine life, since NPV pretty much discounts a long life to zero. Rather, the premium SLW is willing to pay is based on the probability that initial production goals will be achieved in a timely manner and then production is expanded early in the life of the mine.

2008 Jun 13 01:38 PM