Wednesday, June 8, 2011

Thoughts on intrinsic value

I know this post will strike some of you as splitting hairs and an abstraction but it is a topic that fascinates me. A few weeks ago, I got an email asking a very simple question: How do you estimate the "intrinsic" value of gold? This, of course, raised two key questions:
a. What is intrinsic value?
b. Does every asset have an intrinsic value?

On the first question, here is my definition of 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.

This definition then answers the second question. 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.

So, 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. In fact, let's face it: this is the way even assets that have intrinsic value are evaluated for the most part. Thus, the investment banker who takes Groupon public may go through the process of providing a discounted cash flow model to back up the valuation, but the pricing of the IPO will be determined largely by the euphoric reception that Linkedin got a few weeks ago.

I don't intend this to come across as snobbish, but I think we need to clarify terms. Most people who claim to be valuation specialists, experts or appraisers are really pricing specialists, experts and appraisers. In other words, what separates them in terms of skills is in how good they are in finding comparable assets and adjusting for differences across assets. In fact, I have a counter question, when I am asked the question of what the value of a business or stock is: Do you want a value for your business or a price for your business? The answers can be very different.

In closing, though, let me try to answer the question that triggered this post: what is the "intrinsic value" of gold? 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. What makes this monent in economic history disquieting is that we are getting discordant signals from the market: the low interest rates on treasuries (US, German and Japanese) suggests that investors think expected inflation will be low in the future whereas higher prices for precious metals (gold, silver) give support to the argument that investors (or at least a subset of them) believe the opposite. One of these two groups will be wrong and I would not want to be in that group, when there is a final reckoning.

29 comments:

Kumar Gautam said...

I understand gold does not have an intrinsic value. But is there a way we can determine whether assets such as gold are overpriced or underpriced?

Jaime A said...

Great post. I do have some doubts about intrinsic value: Even if you can estimate exactly the future cash flows of a security you are left with the uncertainty of the discount rate, so there is no actual way of estimating an exact intrinsic value, thus the price could simply reflect the different ways our opinions (or expectations) alter the intrinsic value of the asset, right? I do agree that the difference between the price of an asset and its value is an area of opportunity; nevertheless it is not clear that you can arrive at one intrinsic value for a set of future expected cash flows right? In that case if the intrinsic value is am undeterminable value does it still exist, or is it just a hypothetical concept?

Aswath Damodaran said...

If you can estimate the cash flows exactly, there is no risk and you would use the riskfree rate as the discount rate. If you estimate expected cash flow with uncertainty, you will adjust the discount rate for risk and get an estimate of expected value. So, what if it is not precise? Neither is the market price that you are comparing it to...

bankdude said...

I don't believe that gold is an "investment". However, since it is a cash commodity, it can (or should) be considered "inventory". I believe that gold is a worthless asset, but the market says otherwise.

richard tucker said...

do you have a personal view on which group is wrong?

Chandrima said...

Loved reading this, made me think.
I have a very fundamental question- When you sell gold at a particular price, then aren't those cash flows from sale? So cash flows from sale of the good is different from cash flows from sale of produce of a good. Then what is the intrinsic value of consumption goods like food?

Terry said...

If over the long run the real interest rate equals the real growth rate then the current low yields on treasuries could be telling you something about expected future growth rather than something about inflation.

JJ Abodeely said...

Aswath- Thanks for your work, I appreciate your contribution.

Might the "risk free rate" be something that also lacks certitude and permanence in the real world and require its own subjective adjustments? In other words, does what is considered to be risk-free change with time and the opinions of investors, and the actions of men (politicians, central bankers, and the like)? If so, does that limit its effectiveness? And if one were to make adjustments to the risk free rate (like using BAA yields), doesn't that adjustment always come relative to the risk-free rate? For example, while the cash flows for Coca-Cola might be no more or less certain in 1985 as they were in 1995, 2005 or are today, a valuation expert at each moment in time surely would've discounted them differently.

Kumar- I think that there are measures that can determine whether gold is relatively overpriced or under-priced. I would look at gold relative to the monetary base, gold relative to paper assets such as stock indexes (as well as P/E multiples), gold relative to other commodities like copper, and gold relative to interest rates or long-term inflation expectations, among others. While these are are all relative measures, they give insight into its standing versus alternatives.

I intend to write on the topic soon at my blog, www.valuerestorationproject.com

Aswath Damodaran said...

All good points.
To bankdude, you may be right about gold being worthless (in terms of funcitonality) but think of it not as a cash commodity but as an alternative to cash.
To Richard Tucker, I am not sure I belong in either group but I have a feeling that there is a core of truth to both. So, I invest the bulk of my portfolio in financial assets but I have bought hedges against surges in inflation (from TIPs, to commodity, to gold funds).
Chandarima, it is true that you get cash when you sell gold (but that it the only cash flow) and it comes from some one else's perception of what gold is worth. If you think the price of gold is too low, you cannot just hold on to the gold and get an alternative stream of cash flows (as you can from a stock).
Terry, if you are right about interest rates signaling negative real growth, it is going to be catastrophic for most Western Economies since they have budget needs that don't allow for this. Gold may still be your best option.
Abodeely, it is true that riskfree rates vary across time but that does not make them risky. As long as you have the option to lock in a 3% return for the next 30 years today, as you do in nominal terms with a treasury bond or with real terms with a TIPs, you have a riskfree investment.

Krishnan said...

Prof.
Great writing, very informative and thanks again;
I do not wish to digress, from the topic, however how long are TBills going to be risk free? At some point in time the Chinese, Japanese, and other investors are going to wake up and say "Hey, I need to be compensated more for the risks I am taking in financing Uncle Sam"; this may come from the perception that the US may perhaps inflate away their deficit, by devaluing the dollar, in which case the instruments become worthless - thus increasing the risk perception or shall we call it the risk-free rate?
Your thoughts please...
Krishnan

Aswath Damodaran said...

That is a different issue and I do have a post on the question: Here is the link:
http://aswathdamodaran.blogspot.com/2010/07/what-if-nothing-is-risk-free.html

Trustamind said...

Very sharp, indeed!

The author tried to distinguish intrinsic value from the market process of discovering it. The logic is sound and the argument is striking.

But isn't it the intrinsic value itself being set by the market? Such as the rend of a house, the sales / income of a company, etc? :D

Aswath Damodaran said...

The intrinsic value is not being set by the market. It is being estimated by it. If you believe that markets are efficient, then the two will converge. If you do not, all bets are off. (Think Linkedin and Groupon...)

Trustamind said...

Maybe I didn't make myself clear. Intrinsic value of a house is determined by its rent. But who determine the rent, a market. The same thing for a company. Its intrinsic value is determined by how much income it makes. If a company sells products, then its income is determined by the price of its products. Again it is a market that set the price of the product. Yes the market is not a financial market. But it appears that market is the only way to discovery and realize value in human society.

Anyway I was trying to be humorous, not trying to make an argument. It's a pity it didn't go through...

Aswath Damodaran said...

Ah, I see what you are getting at. Rents are determined by demand and supply in a market. Fair enough. In many ways, one of the problems with financial asset markets is that they are markets for financial assets overlaid on markets for real products and services. In intrinsic value, you are estimating the value of financial assets, given the real product market below. You could conceivably carry intrinsic value one step further and ask whether the rental market is intrinsically fair...

Trustamind said...

Sure no market is absolutely fair. But we have to live with it. Probably take advantage of it. :)

Dave said...

Just a thought. If one views the gold as a functional metal for conductors and the like, it should have a intrinsic value of whatever cash flows can be created with the it. Granted that it is probably miniscule, and that's not what you're paying $1,543 an ounce for.

essentialassociate said...

Loved reading the post. I have a point to make. That is it worth investing in gold right now as the said asset does not generate any cash flow (only capital appreciation) and seems to be in a bubblish territory?

Aswath Damodaran said...

Dave,
Your point about gold's functionality is a good one, but you are also right. If it were priced based on that, its value would be tinry, relative to its fair value.
Essentialassociate,
You may be right about it being in bubble territory, but for better or worse, it remains a powerful hedge against a complete failure of the monetary authorities...

Saurabh said...

Professor I might sound irrelevant to this post, but I request you do a write up on Quantitative Easing 3 - "Does America need it?".I was reading Krugman and he sounded confident that resorting to any more cuts and not injecting money will spell doom for the US economy.This topic is all the more relevant given the fact that Fitch is planning to downgrade US if US fails to raise its debt limit before August.Looking forward to your response :)

Regards,
Saurabh

Eugene said...

To add to Saurabh's comments, I personally believe QE3, or some variant of it, has to happen as the US is still stuck in a balance sheet recession. Consumers are not spending enough and private sector is not investing enough but I hope this change by next year...

Would appreciate Prof. Damodaran's take on this as well!

Unknown said...

Hi,

I believe that gold has an intrinsic value.

Let us change the question a bit. Suppose I ask, what is the intrinsic value of a $100 bill? You cannot say that it has no intrinsic value because it does not generate cash flow.

The value of the $100 bill is set based on how many $100 bills there are in circulation. As the supply of $100 bills increases, its market value decreases even if its nominal value remains the same. This is basically how inflation works.

The same concept applies to a bar of gold. Its value depends mostly on how much of it is circulating and available to the market.

Unknown said...

Hi,

@Eugene. Quantitative easing is in essence a waste of tax payer money. Indiscriminate spending, as advocated by Keynesian Economics, is flawed. In fact, it has been proven to be flawed many years ago -- yet politicians advocate it because it is so simple and it makes them look good.

Quantitative Easing does not work. Suppose the US government gave every man, woman and child in the country a $100 bill. The act would be meaningless because goods and services would simply charge more for the same amount, and people would spend proportionally more for the same amount. So there really is no positive net effect.

What the government needs to do is (1) Stop wasting money on useless wars. (2) Invest in infrastructure that will help foster innovation, increase productivity and reduce expenses.
(3) Maybe pay off some of that debt, maybe. Austerity programs are not in vogue now since what happened in Europe but doing so may increase confidence in our monetary system.

Raghav said...

Gold has proven to be most liquid and reliable asset for centuries. Had it been abundant availability of gold then it could have proved to be not so useful metal. If we see actual use of gold as a metal it is not much. I was reading article about gold where author said if interest rate in a country is lower than inflation people prefer to buy gold as a better investment. Gold can’t provide stream of cash one can gain from it only when the price of the gold increases. It is like your home which can’t be an asset and does not provide you cash flow (It certainly avoids your cash out flow). One has to sell gold to realize gain and that is the end of the story. Assets like a machine can give you cash flow over the period of time and also has value of its own. When we say cash flow, machine is being useful for someone and someone is ready to pay for that. In case of gold it is of no use. Even an employee will have an intrinsic value as it generates cash flow for the company and one can value a person in terms of intrinsic value.
If we look at it in other way say in 1960 with the price of 1gm of gold one was able to buy say 1000 eggs even today proportion might be similar with some adjustments( I have not calculated it). In my opinion gold will have approximately a somewhat fix ability to buy any bench mark commodity. As there will be inflation value of the gold will be adjusted according to it.

Raghav said...

other view is
Paper money has replaced gold as a currency over the period of time. If we have to find intrinsic value of gold we can convert it to money at current market rate and consider current interest rate in market which will provide cash flow. Discounting it to present we may get intrinsic value of gold.
I strongly consider that something is missing in the logic any inputs on this

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Sunshine Coast Bookkeeping said...

Now I know that gold doesn't have an intrinsic value but rather it has relative value. Thanks for pointing it out.

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