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XMFRedwood (93.56)

How To Value Gold

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August 20, 2010 – Comments (23) | RELATED TICKERS: GLD , IAU , GG

Have you seen this video that mocks gold owners?  It shows how it's easy to twist reality 180 degrees and make it funny at the same time.  Congratulations to the author (director?) on a nice piece of verbal sleight of hand. 

The video is illustrative of the fact that many people hold a negative opinion on gold without having done any research on it.  I’ve seen stories in the Wall Street Journal saying gold has had a tremendous run up and it’s becoming more mainstream, so it’s probably overvalued, etcetera, etcetera.  This is the laziest form of analysis and in fact, isn’t analysis at all.  You can’t make an informed conclusion on a subject unless you have examined the evidence thoroughly, which clearly the WSJ and others haven’t.  An opinion on gold that doesn’t examine drivers of gold demand is like an opinion on a company without knowing its products – fun, but useless. 

I'm a bit surprised people think gold has little or no intrinsic value when it is plainly obvious it does.  One argument I hear is that in the commodity realm, gold isn’t as good as oil because oil has industrial uses.  But what is the goal of industrial activity?  To fulfill human desires – for products, transportation, warmth, etc.  Oil performs that role admirably.  Yet humans also desire a safe place for wealth and gold performs that role extremely well over time.  Both commodities fulfill human desires.  Both fluctuate.  So I’m not sure if I see the difference.  Additionally, the marginal-cost approach deflects attention from the real driver of value – demand. 

Valuing Gold

I’m not surprised people are flummoxed over how to value gold – it’s fairly complex – but saying it can’t be valued is presumptive without deep knowledge of the subject.  

What people and even the WSJ miss is they start their valuation with gold and its price, a strategy akin to predicting how high a corn stalk will grow by looking at the seed.  Sun, water, and nutrients determine how high corn will grow.  Likewise for gold.  Gold’s price is the effect, the result, not the cause.  Other forces drive gold’s price including its supply, amount of dollars are outstanding, popularity of equities, bonds, cash, real estate, confidence in government & authorities, confidence in the economy, & many other factors.  We must examine these forces to value gold.

It’s obvious there are no cash flows to ground a traditional valuation, but that doesn’t mean gold has no value.  Even cursory thoughts on gold or other commodities would come to that conclusion.  With knowledge of the future anything can be valued, gold included.  The question is how well we can forecast the future.  And based on analysis of the drivers above, I believe we can determine a range of prices for gold – both an anchor price and a range of likely future prices. 

First, it’s obvious that gold is nowhere near its prior highs in relation to inflation, equities, or money supply.  This provides context.  Second, lack of confidence, fragility and inflationary structure of the world’s financial system, poor economic growth prospects, and demand from central banks all point toward much higher prices for gold. 

Like with companies – we can only make our best prediction as to their future worth.  At this point I have a near term anchor price of $1,000/oz for gold and I think it could go to $8,000/oz in certain situations. 

Valuing gold is complex, sometimes excruciatingly so, and might be open to claims that it can’t be done, but I’ve yet to hear informed opinions as to a) why it can’t be valued or b) why its value is lower than $1,000/oz. 

At certain points gold can be valued correctly and one of them is now.  It’s everyone’s right whether or not to accept that value, but I’d caution on relying on broad judgments made by people that haven’t examined the situation in the requisite amount of detail. 

Andrew

23 Comments – Post Your Own

#1) On August 20, 2010 at 2:40 PM, binve (< 20) wrote:

Hi TMFRedwood,

I saw that last week too: http://caps.fool.com/Blogs/i-do-not-care-i-want-gold/433260. I agree with all your thoughts on how to value gold. Let me offer a few more: http://caps.fool.com/Blogs/contraryinvestor-the-many/400090.

Thanks!

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#2) On August 20, 2010 at 2:44 PM, binve (< 20) wrote:

Here is where the second link should ultimately lead you : http://www.contraryinvestor.com/2010archives/mojune10.htm

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#3) On August 20, 2010 at 3:09 PM, blake303 (29.84) wrote:

At this point I have a near term anchor price of $1,000/oz for gold and I think it could go to $8,000/oz in certain situations. 

How did you arrive at these figures?  Without further detail or explanation, how do we know that your analysis is more useful or informed than the WSJ? 

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#4) On August 20, 2010 at 3:39 PM, MegaEurope (21.23) wrote:

Why did you type all those words instead of telling us how to value gold?

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#5) On August 20, 2010 at 3:48 PM, XMFSinchiruna (28.54) wrote:

excellent thoughts and discussion Andrew.

Given the nuanced process involved, the safest way to value gold is to remain incredibly and consistently conservative. This is why I have not moved the goalpost of my $2,000 price target over the past few years despite a steady accumulation of fundamental drivers for higher prices over that time.

When value investors face uncertainty in pegging a specific fair value for a company that presents some opacity for one reason or another, they adapt to that condition by employing added conservatism in their calculations. 

The admitted challenge with valuing gold is that I could sit here and propose a vast range of potential fair values based upon a range of future scenarios. For example, one can use Adrian Douglas' very compelling research to calculate a fair value above $48,000 per ounce if the scenario we are valuing for includes a collapse of the paper-induced leverage in the global gold market (primarily through the London OTC).

Others might just as convincingly argue that valuing gold has more to do with pricing-in the balances of payments of the more salient debtors like the U.S ... i.e. what the gold price would have to be in order for the global supply to match those key balances of payments.the result would be well into five figures per ounce, but well below the above mark (I think it was around $30,000 at last check).

A more conservative valuation could be constructed merely on the basis of estimating the impact of price suppression that has thus far muted gold's decade-long move. Adrian Douglas' latest report proves that a covert gold pool has suppressed the price by consistently dumping gold into the London pm fix over the course of the decade. Had suppression never been in place -- and admittedly this is not a quantitative process but rather a qualitative assessment based upon my daily scrutiny of this market over the past 6+ years, I feel comfortable suggesting that gold would already be trading in the $2,200 to $2,500 range absent all manner of coordinated suppression activity.

And then there is an endless parade of alternative scenarios that a seasoned gold observe can apply to price projections much the way oil analysts work in contingent scenarios like an armed conflict in the Straits of Hormuz into their oil price projections. For example, another $700 billion bailout or massive resumption of quantitative easing could be estimated to appreciate the gold price by X. A wholesale increase in China's gold reserves could be estimated to increase the gold price by Y, and likewise, and further advances from less impaired nations to adopt an alternative reserve currency regime with a reduced role for the U.S. dollar and/or the Euro could be estimated to appreciated the gold price by Z.

It's definitely an inexact science with plenty of ifs and buts, but much like placing a fair value upon an opaque company, there is room for different analysts to come to different conclusions ... the real confidence is found in taking the lowest common denominator of myriad valuation attempts / procedures.

This is why I am sticking with $2,000 for now. As we approach $2,000, I expect far greater visibility for determining whether $3,000 or $5,000 might make a conservative secondary price target, or whether instead some miraculous confluence events might have by then reduced the likelihood of further parabolic price moves.

These are merely the rambling friday afternoon thoughts of one Fool. Every Fool will likely come to a different conclusion on fair value. My own range is anywhere between $2,000 and $48,000, which is why I stick with $2,000. :)That being said, I will be shocked if we get through this whole mess without seeing $5,000 gold, and I also see plenty of scope for 5 digits.

Thoughts?

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#6) On August 20, 2010 at 4:01 PM, XMFSinchiruna (28.54) wrote:

P.S. Just a reminder about silver.

Gold's move from here to $2,000 will represent a 60%+ move, but by the time we advance to that stage, silver can be expected to be trading at a gold-to-silver ratio beneath 50:1 ... more likely 40:1 in my long-pondered estimation. This is why I equate a $50 silver price with $2,000 gold. The difference here is one of percentage gains ... silver's move from here to $50represents a move of more than 175%. This is why the vast majority of my precious metal exposure is allocated to silver.

In other words, relatve to the USD, gold is extremely cheap. Relative to silver, however, gold is quite expensive. More than 80% of my total equity exposure is allocated to precious metals, and of that 80% I think about 70% of that is targeting silver specifically. SLW alone is nearly 20% of my portfolio, having grown to surpass my CEF holding (50/50 gold/silver) by quite a margin.

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#7) On August 20, 2010 at 4:30 PM, XMFRedwood (93.56) wrote:

Demand is very strong and supply is limited.  There is a lot of room for demand to get stronger, pushing the price up.  

Demand is coming from both investors and non-G7 central banks.  Saudis, Russia, India, and China are big buyers, and so would be the G7 if they could -- the best they can do is stop selling, which they have done and is a clear sign.  Confidence in paper currencies (the dollar particularly) has been remarkably strong but will continue to evaporate as governments continue their decades-long (wait, millennia-long) tradition of devaluing their currencies.  As confidence wanes, gold will go up.  The benefit of gold over oil is that gold is much better suited for money, which it in fact is.  

People talk about fear driving the price but while this is part of recent strength, we aren’t even close to where we were in 1980, and I’d argue today’s environment is even worse.  The U.S. gold stock as a percent of M2 at today’s prices stands at roughly 3.5%.  In 1980 this figure got to 12%.  That same ratio would put us at a $4,000 gold price but you know that past performance is no indication of future results: it could go higher this time around.  Either way, central banks are setting at floor at about $1,000 or higher and there is vast upside.        

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#8) On August 21, 2010 at 10:08 AM, MoneyWorksforMe (< 20) wrote:

TMFRedwood,

Thank you for this post. You touch on key areas of common confusion among investors.

Gold bears simply point to the run-up in gold price over the past decade to justify that it must go down. But the problem with this analysis is that the fundamental drivers of gold prices have only increased dramatically during this time, particularly over the past few years and especially more recently. When the fundamentals change, that is when a meaningful correction should be expected and ultimately observed.

Saying gold must decline simply because it is attaining all-time highs is the same as asserting a company's stock must fall simply because it is at a 52-week high, (AAPL in my mind is a perfect example) or the Dow--at some point in the future--is due for a correction because it made its way back over 14,000.

Fundamentals will always prevail; and as of right now, the fundamentals for robust and increasing gold prices couldn't be much better....Over time more investors will learn to appreciate these fundamentals by beginning or increasing their gold positions.

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#9) On August 23, 2010 at 11:03 AM, FreeMortal (29.94) wrote:

I'm not an anti-gold crusader, but I still have not seen a convincing argument that gold has an intrinsic value anywhere close to its present price.  It has minor industrial utility, but no where near copper or aluminum.  It worked well as a medium of exchange before the modern era because it is fungible, transportable, and did not tarnish over time. Salt was used for the very same thing --although it arguably had much more utility, especially for the time.

Napoleon appropriated tons of gold during his invasion of Russia, only to leave much of it behind on his humiliating march home.  At that point, with his army starving, it had little value at all.

The best argument I've seen for gold is from the demand-side. Loose monetary policy around the globe is adding even more fuel to this demand --for the moment anyway.  A growing world middle-classs may fuel demand for gold the longer-term, but they will demand many more things than gold --like cars and coffee.

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#10) On August 23, 2010 at 11:26 AM, ETFsRule (99.90) wrote:

Isn't it easy to predict the "fair" value of gold? Just plot it against the money supply, as they do in figure #4 at this link.

After all, the value of gold isn't really changing (in terms of gallons of milk, loaves of bread, etc). It is just the value of our currency that is changing.

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#11) On August 23, 2010 at 11:30 AM, ETFsRule (99.90) wrote:

TMFSinchiruna:

How did you come up with your predictions for the gold:silver ratio? From the sources I have read, no one really seems to know what the "correct" gold:silver ratio should be... because, no one knows exactly how much of these metals there are on this crazy planet of ours.

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#12) On August 23, 2010 at 12:45 PM, XMFRedwood (93.56) wrote:

ETFsRule - Very nice chart!  You've also hit upon the crux of the issue in your post- gold still buys the same amount of "stuff" (smoothed out over time) because the quantity of gold is relatively fixed (only 1-2% annual growth).  Gold's rise simply says that currencies have lost value (or perceived value).  

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#13) On August 23, 2010 at 2:17 PM, silverminer (39.38) wrote:

ETFsRule

Geologists believe that silver is approximately 15-times more prevalent (less scarce) than gold throughout the totality of the Earth's crust. That ratio of natural occurence, interestingly, roughly matches the very long-term historical price ratio of about 16:1. In other words, over the very long-term, market values for the two metals coalesced right around the ratio of their relative scarcity, suggesting that worldwide production has yielded approximately the same ratio that geologists have modeled for.

The anticipated gold to silver ratio of at least 40:1 during the present bull market event, and potentially reaching 30:1, results from conservative analysis of historical (though still modern) price relationships, independent of that ratio of relative scarcity. Since supply always exerts its influence eventually, though, I anticipate an eventual return to 20:1 or lower at some point over a very long time horizon (perhaps not even in our lifetime ... but eventually).

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#14) On August 24, 2010 at 2:14 AM, MegaMicrocap (< 20) wrote:

Claiming that the value of gold is not changing is totally absurd.

ETFsRule, check the historical prices of gold, bread and milk.  You will find that reality conflicts with your theory.

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#15) On August 24, 2010 at 9:56 AM, silverminer (39.38) wrote:

MegaMicrocap

Absurd? Over the long-term, smoothing out the hills and valleys of near-term volaility, gold absolutely is the steady measure of purchasing power around which the paper currencies trade.

In Endeavour Silver CEO Bradford Cooke's words:

A lump of gold, you know, doesn't change in value from year to year or century to century. A lump of gold is a lump of gold. It's how we measure -- what we use to buy and sell it -- that changes.

 

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#16) On August 24, 2010 at 12:18 PM, MegaEurope (21.23) wrote:

You seem to have a theoretical belief that gold's purchasing power is steady over time.

Have you actually looked at the data over the last 40 years and tried to reconcile this belief with reality?

I find flat assertions and appeals to authority totally unconvincing, so I suggest you drop that line.

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#17) On August 24, 2010 at 12:33 PM, ETFsRule (99.90) wrote:

TMFRedwood and silverminer: Thanks! Great responses so far... now if I can just put this to work and make some $$$...

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#18) On August 24, 2010 at 1:13 PM, MegaEurope (21.23) wrote:

ETFsRule, did you notice that your source implied that gold is somewhat overpriced compared to M0?

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#19) On August 24, 2010 at 1:52 PM, FreeMortal (29.94) wrote:

I'm still a neophyte in the gold scene.  I hope maybe some of you will be able to answer a couple of questions.

Silverminer - Why is the gold/silver ratio so out of sync now with what they would be out of scarcity alone?  How is this condition changing?

ETFsRule - You link provides an analysis of gold compared to the narrowest definition of money supply. Why do they exclude all that information?

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#20) On August 24, 2010 at 4:28 PM, ETFsRule (99.90) wrote:

Mega: yes I did. Although I hope you noticed that the analysis only goes up to late 2008. It was with methods similar to this, that Paul Van Eeden was able to conclude that gold was overpriced by about 25% in 2008. He was right, and in 2008 there was a correction that matched his prediction almost perfectly. Since 2008, gold has continued climbing in value (and, unsurprisingly, the money supply has continued to increase). So, the method seems to work pretty well.

Right now, I am not exactly sure if gold is overpriced or underpriced, because I don't have all the up-to-date information that I would need to do my own analysis. But I suspect that it is a bit overpriced right now due to its gains over the past 18 months.

Freemortal: That's a good question, maybe you should ask them. What definition would you have used?

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#21) On August 25, 2010 at 12:07 AM, FreeMortal (29.94) wrote:

#20  I'd have used M2 or M3.  The M0 includes no checking accounts, savings, CD, or money market.  Most of us see very little of our paychecks in hard cash --most of our 'money' is in the banking system.  Yet we all include it when considering our liquid worth. 

M1 M2 and M3 are dependant on the monetary base and the multiplier effect of the banking system.  Banks are lending less now than usual which is holding down the multiplier.  The result is a much smaller money supply (in the broader sense) than would otherwise be given that monetary base.  Of course, we expect this condition to change, and when the banks finally do start lending more, the broader money supply could make a great leap.  If this happens, it seems to me that this would be a boon to gold owners.  This could happen even if the monetary base doesn't change at all.

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#22) On August 25, 2010 at 8:44 AM, XMFSinchiruna (28.54) wrote:

FreeMortal

Silver is a smaller market and therefore easier to suppress than gold. Bullion banks have very effectively contained the bull market in silver thus far, and the London trader who blew the whistle on that daily activity corroborated the long-held observations of experts in the silver industry.

Moreover ... gold always leads and silver always follows. I have explained this relationship as being like a slingshot tether tied between the two. Gold moves higher while silver stores potential energy to make its own move later. 

MegaEurope

You are speaking to someone who knows a thing or two about gold. I do not have a "belief" about the stable purchasing power of gold, but rather a defensible position based upon observable facts. Have you checked the gold chart against the USDX chart lately? The USD has shed purchasing power at an alarming rate since Nixon closed the gold window, while gold has appreciated in USD terms to reflect that deterioration. There are short-term peaks and valleys that make it appear that something else might be going on, but ultimately gold is merely reflecting the reduced purchasing power of the major unbacked paper currencies (esp. the USD).

You may be familiar with the most common example cited to make this point. It is actually quite accurate over the course of several centuries. An ounce of gold has consistently tended to reflect the approximate cost of a fine-quality, custom tailored men's suit. 

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#23) On August 25, 2010 at 1:08 PM, ETFsRule (99.90) wrote:

FreeMortal:

Good points. After looking at this graph, I would say the M3 would probably be the best indicator to use. This would show a larger % increase over time than the M0 - meaning that the fair price of gold is likely higher than what was implied by the graph of M0 vs gold value.

On the other hand, my link was referring to the global money supply (not just USA). On a global basis we might not see such a large difference between the % change in the M0, and the % change in the M3.

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