A good read on this holiday. Happy Thanksgiving.

Determining the value of gold

2012-SEP-29

When considering whether gold is a value investment, one needs to first recognise that gold does not have a balance sheet, management team, price-earnings ratio or any of the other things one needs to analyse before making an investment. Also, gold does not generate any cash flow, so it does not pay a dividend. We can therefore conclude from these observations that gold is not an investment. Indeed, it is something different, which means that normal investment analytical techniques cannot be used to determine gold’s value.

Value of course arises from an item’s usefulness, and gold is useful because it is money. Though only used as currency these days in a few places like Turkey and Vietnam, gold is still useful in economic calculation, or in other words, measuring the price of goods and services.

For example, when the Maastricht Treaty was signed in February 1992, one barrel of crude oil cost $19.00, €15.95 (Dm 31.30) or 1.67 goldgrams. Now it costs $91.79, €71.27 or 1.61 goldgrams, which makes clear that not only is gold useful in communicating prices, it preserves purchasing power. Gold has been useful in these ways for over 5,000 years, so it is logical to assume that gold will remain useful for the foreseeable future.

Some say that the gold price rises and falls, but they are grabbing the wrong end of the stick. It is the purchasing power of national currencies that rise and fall. Here is an analogy to make this point clear. When standing in a boat and looking at the shore, it is the boat (currencies) – and not the land (gold) – that is bobbing up and down.

Currency fluctuations occur in the short-term, but over the long-term, a currency’s purchasing power is continually eroded from inflation and other debasements inflicted on it, as is clear from the example above showing changes in the price of crude oil. There is, however, a subtle but more important point to make here.

Gold does not create wealth. It cannot possibly do that because it does not generate cash flow. Remember, gold is not an investment; it is money, and these two things are entirely different. So when the price of gold rises, wealth is simply being transferred from people who hold currency to people who hold gold. This wealth being transferred already exists. It is wealth held in the form of purchasing power.

Lastly, is gold good value? This is a question that each of us must answer by ourselves because value is subjective. But to me the answer is clear. Gold is indeed good value because it is a useful money, not prone to the problems perennially plaguing national currencies.

Further, gold is good value because it is not over-priced, a conclusion that can be reached by simply considering supply and demand. Even though the gold price has been rising this past decade, the supply of national currencies is being created much faster than the supply of gold. Second, the demand for gold understandably continues to rise as it offers a safe-haven from the ongoing turmoil of the interrelated bank insolvency and sovereign debt crises that have been riling national currencies. These crises have not ended, so I expect this supply/demand relationship will continue. Therefore, gold will become more highly valued in the months ahead, meaning that its purchasing power will rise.

At some point in the future, which cannot be predicted, gold will become overvalued. Its purchasing power will exceed historical norms. To give but one possible example, maybe a barrel of crude oil will only cost 0.50 goldgrams or less. When that moment arrives, it will be time to reduce your gold holdings to buy undervalued investments or to purchase some consumer goods with your savings, which is the gold you are accumulating now while it remains undervalued. I suspect that we are still many months, if not years, away from that event because gold is far from being overvalued.