How do you calculate the value of gold?

May 30, 2019

Around two years ago, Professor Aswath Damodaran predicted that digital currencies will eventually be as important as the major paper currencies, and believed that cryptocurrencies have already replaced gold for younger investors.

In an interview with CNBC, Damodaran stated that “All currency is ... based on trust. If you don’t trust paper currency, historically what you’ve done is you dumped paper currencies and bought gold. Cryptocurrencies have taken the role of gold, at least for younger investors because they don’t trust paper currencies.”

The professor of finance at the Stern School of Business, New York University, has also written about the value of gold – intrinsic and relative.

What is intrinsic value?

It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk. The essence of intrinsic value is that you can estimate it in a vacuum for a specific asset, without any information on how the market is pricing other assets (though it does certainly help to have that information).

At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk.

Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant's estimate of what fixed and current assets are worth is the true value of a business.

Does every asset have an intrinsic value?

Only assets that are expected to generate cash flows can have intrinsic values. Thus, a bond (coupons), a stock (dividends), a business (operating cash flows) or commercial real estate (net rental income) all have intrinsic values, though computing those values can be easier for some assets than others.

At the other extreme, fine art and baseball cards do not have intrinsic value, since they generate no cash flows (though they may generate a more amorphous utility for their owners) and value, in a sense, is in entirely in the eye of the beholder.

Residential real estate is closer to the latter than the former and estimating the intrinsic value of your house is an exercise in futility.

How do people value assets where intrinsic value cannot be estimated?

They look at what other people are paying for similar or comparable assets: i.e., they use relative valuation. Thus, an auction house sets a value for your Picasso, based on what other Picassos have sold for in the recent past, adjusted for differences (which is where the experts come in). The realtor sets the price for residential real estate, based on what other residences in the neighborhood have sold for, adjusted for differences again.

Does gold have intrinsic value?

The intrinsic value of an asset is a function of its expected cash flows, growth and risk. Since gold is a non cash-flow generating asset, you cannot estimate an intrinsic value for gold. It is the same argument I would make about all collectibles: Picassos, baseball cards or Tiffany lamps included.  If one of the central tenets of value investing is that you should never invest in an asset without estimating its value, that would seem to rule out gold as an investment for a classic value investor. In fact, Warren Buffett has repeatedly argued against investing in gold because it's value cannot be estimated.

Does gold have relative value?

In my view, gold does not have an intrinsic value but it does have a relative value. For centuries, gold (because of its durability and relative scarcity) has been an alternative to financial assets (that are tied to paper currency). Unlike the gold standard days, where the linkage between paper currency and gold was explicit, the value of paper currency rests entirely on trust in central banks and governments. As a consequence, the price of gold has varied inversely with the degree of trust that we have in these authorities.

Though not a perfect indicator, gold prices have surged when a subset of investors have lost that faith, i.e., they fear that the currency is being debased (inflation) or systematic government failures. Through the centuries, gold has been the “asset” of last resort for investors fleeing a crisis.

There is an alternate route that can be used to estimate the "fundamental" value of a commodity by gauging the demand for the commodity (based on its uses) and the supply. While that may work, at least in principle, for industrial commodities, it is tough to put into practice with precious metals in general, and gold, in particular, because the demand is not driven primarily by practical uses.

Source: Thoughts on intrinsic value and Thoughts on gold as an investment

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