Risk Latte - Valuation of Assets & Commodities and the Inflation Conundrum

Valuation of Assets & Commodities and the Inflation Conundrum

Rahul Bhattacharya
Jul 27, 2007

Seldom do we come across stellar articles in the newspapers; articles that not only inform us but also educate us on some key social, economic or political issue. The newspaper that we believe will score the highest on this point is The Financial Times published in the UK. However, very recently we came across an article in the International Herald Tribune that we found extremely educative and of very high value added. The article was titled "The Illusion of Investment Profits" and the author was one David Leonhardt. It was published on the July 18, 2007 and we think it was a brilliant article. This prompted a lively debate within our team over a couple of lunch and coffee breaks. Here are our thoughts and what we could glean from the article.

The key to the valuation of any asset lies in the value of the money, for we value everything with money. Not that we have to. We could value a loaf of bread in terms of the calorific satisfaction that it affords us. We could say that the value of a loaf of bread is X calories. Or we could value the said loaf of bread in terms of, say, ounces of gold and by making a comparison like we would derive the same satisfaction from a loaf of bread as we would from say, 0.005 ounces of gold. So we could say that a loaf of bread is worth 0.005 ounces of gold.

This would be very cumbersome and would make our daily lives very complex. Besides, valuations of assets (your house, apartment, car, stocks) or commodities (groceries, metals, oil, etc.) would have no uniform benchmark. You could value a loaf of bread in terms of calories and someone else could value the same loaf in terms of ounces of gold. Eventually, we would have to invent a common denominator to translate this value. Thankfully, human beings found that common denominator hundreds of years ago and we know it as "money".

All this may sound pretty trivial and perhaps it is. But hidden in this concept of "money" is the fact that "money" itself has value. And this is a moot point. Its value can go up or down - i.e. we could be in a deflationary or an inflationary environment. You can think of money as a piece of paper or simply as a benchmark - a common denominator, if you will - with which to value all your assets and investments. But by doing so, you would be overlooking the fact that you are in essence valuing one asset (or a commodity) with another. It is exactly the same, in meaning, as valuing a loaf of bread with gold.

Actually, the value of an asset can be written as (Economics gurus and students please forgive us if we are oversimplifying this issue):

Nominal Value = Asset (Real) Value + Inflation

The same will be true for any commodity - the commodity's nominal value, the value we see printed on the loaf of bread in the supermarket, would be the real value plus inflation (inflation can be a positive or a negative number).

Inflation is the value of money. In an inflationary environment the value of money falls and in a deflationary environment the value of money rises. If the supply of money increases in the economy, due to governments printing more money, then inflation rises prompting a rise in prices of cars, groceries, apartments, and other goods and this essentially means that the value of money falls (too much supply of money chasing too few goods). In that respect you can think of "money" as a commodity which has its own demand and supply dynamics.

Say, a loaf of bread cost $1 in the year 2000 and today it costs $2. You would say that the nominal value of the loaf of bread has indeed doubled in the last seven years. In the same breath you would have to say that the value of money - with which you are measuring the loaf of bread - has halved in these past seven years. Even though this may seem absolutely trivial and a pure mathematical exercise, the implication is quintessential to understanding the value of a loaf of bread, or for that matter any commodity or an asset.

Has the loaf of bread really increased in real value? To get the real value of the loaf of bread we need to subtract inflation from the nominal value of $2.

Very few of us would realize it but it is a trivial fact of life that over a long period of time value of "everything" (assets and commodities) rises. Inflation is a secularly rising trend. Why does it come to us as a surprise then that price of real estate in Mumbai or New York has more than doubled over the past 10 or 15 years? Why does it come to us as a surprise that the price of loaf has gone up sharply over the past 20 years?

And therefore, why are we so jubilant that the stock markets around the world - stocks are assets as well - have hit record high recently? This is the basic argument of the article that we refer to published in IHT. Over time governments print more money and hence the price of everything rises; so the price of stocks would also rise. And of course, the incomes of people would also rise. And this may imply that everything is getting more expensive and at the same time all of us are getting richer. But that is not true. Assets and commodities cannot get more expensive in terms of money while at the same time we get richer. This is a contradiction in terms.

Has it ever occurred to you that in terms of the real value of assets your grandfather may have been far richer than you are today?

Over the long run the value of money gets destroyed and hence to value an asset properly one needs to first get a grip on the value of money.

Note: Inspired by the brilliant article, "The Illusion of Investment Profits", by David Leonhardt, in the International Herald Tribune dated July 18, 2007 .

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