Earlier this year, I did a first attempt to value gold. The problem with gold is clear: it is incredibly difficult to value an ounce of gold, because we have no yardstick or underlying value to measure gold against. Better put: we can value a company by estimating the future discounted cash flows that the company is able to generate. Subsequently, we can compare our valuation (the company’s “underlying value”) against the current stock price (the “market value”), with the knowledge that the market value in the long run always tends toward the “underlying value”. Yet, how could we possibly compare the “underlying” gold replacement value against the current gold price?
What exactly did I do in January this year?
I did the following: I looked for an anchor against the gold price, against which I could compare the current gold price. Of course, as I wrote earlier, the returns on capital markets (primarily interest rates) is leading for returns on gold: all other things equal, gold prices rise against a backdrop of low interest rates and decline against a backdrop of high interest rates. After all, interest rates reflect an opportunity cost for holding gold, and this relation is largely backed by empirical data. Nonetheless, this does not tell us anything about how to value gold, or whether a gold price of $1,200 per troy ounce is “expensive” (overvaluation) or “cheap” (undervaluation).
The most important requirement for determining under- and overvaluation is that we can state with apodictic certainty that the gold price will tend to this very level.
This is, for example, not the case of the gold/silver ratio. This ratio, which currently stands at approximately 1:84 (because: a gold price of $1210 divided by a silver price of $14.40). The past decade the ratio’s highest point was 1:88 and its lowest point 1:30. Historically, as some experts assert, the mean ratio would be around 1:16. This level is, moreover, “backed” by the fact that the natural scarcity of the two precious metals is roughly equal to this ratio: silver occurs about fifteen times more often in nature than gold.
The issue with the gold/silver ratio should be clear by now: there exists no single reason why this ratio would have to tend to 1:30 or even 1:15. No mechanism should lead us to suspect that the gold/silver ratio enjoys this built-in tendency. For all we know, the gold/silver ratio could even double: we would have no clue, at least by looking at the ratio in isolation. There does not exist a “regression to the mean” with regard to the gold/silver ratio: our yardstick, in this specific case, does not serve its purpose as yardstick.
Now, my approach to this issue was quite different last January:
We want to get our hands on a troy ounce gold bar. How can we go about doing this? We can either buy the bar on the open market (against current market prices) or we could mine and melt the gold ourselves. Now, the latter might sound rather sensational or a little bit too optimistic, but there is a grain of truth to it.
Mining and melting “our own bar of gold” is in fact the replacement value of gold. And despite the fact that we might not be able to actually mine the gold ourselves, other (professional) third parties can do so if the price differential with the market price is sufficiently large. And vice versa. If the replacement value of gold exceeds the market price, then why not simply buy bullion on the open market? Thus, there exists a regression to the mean: the replacement value of gold can never exceed by much the market price of gold.
To do so, I took Barrick Gold Corp as an example. I derived, in January, when gold prices were still far above $1,300 per troy ounce, a replacement value of $1,236 dollar per troy ounce of gold with Barrick Gold. At the time, this implied an overvaluation of 10%, since gold prices stood at $1,350 dollar per troy ounce.
Recent history proves that, apparently, I did a decent job in proxying gold’s replacement value. Gold prices dropped to below $1,236 (and are currently hovering around $1,200/oz), while earlier this year gold prices stood almost hundred dollars per troy ounce higher.
Even without repeating all the work from zero, I could opt for changing just two variables: (a) the stock market price of Barrick Gold Corp (this is one of the values I used at the time to proxy the replacement value of a troy ounce of gold) and (b) the current gold price.
I assume, therefore, a stock price of $10,50 per share for Barrick Gold (in our earlier model, Barrick Gold was still above $14 per share).
This provides us with an amount of approximately $142 dollars, which we would have to put up to obtain a troy ounce of gold in the ground, legal property of Barrick Gold. Because Barrick extracts gold at an annual rate of about 6.5% of its (proven) gold reserves, we would have to adjust our $142 for this annual rate of extraction. This gives us $365.20 for a troy ounce of gold. We should add to this amount the all-in sustaining cost of Barrick Gold (of $730, which includesallthe costs that Barrick incurs to mine a troy ounce out of the ground/rock, which provides us with a “replacement value” of $1,095.20 for a troy ounce of gold.
If we compare this replacement value against the current gold price ($1,210/oz), then this implies an overvaluation (in the short run) of slightly more than 10%. If this (simplified) model has any validity, then we should consider the possibility of some downside for gold in the short run. Gold prices could easily fall by another hundred dollars, at least, if the information priced into gold mining stocks is correct.
It should not be a surprise that I still anticipate a stronger dollar and lower gold prices in the short run. But that does not imply that gold is a bad investment. Being a contrarian could lead to great rewards. Moreover, for an investor who pays taxes in euro’s and keeps its books in euro’s, this tendency (stronger dollar/lower gold price in dollars) could easily even out.
Waiting too long for a correction can also turn out to be counterproductive, because we – as long as we do not hold a position in gold – cannot be protected against some extreme, unexpected scenarios that have a large (negative) impact, something Nassim Taleb calls “black swans”.