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Valuation, a thought !

Valuation is a subjective term, when we talk about valuation we deal with many alternative opinions, theorists consider valuation as an outcome of market forces, but the understanding of market forces need a thought.

You can consider the example of Coconut Water for understanding the complexity of valuation. Technically speaking the market price of a product depends on cost and profit margin over it, the cost can be similar for a product if it is being produced/grown in a similar environment. Having similarity of cost, the price of Coconut water will be different at Chennai and New Delhi, the difference is a result of variation in the demand of the product which is not simple mathematical function but a derivation of many qualitative things like location, people’s preferences, choices, etc.

Recently we heard a new term Cryptocurrency and that Bitcoin, the first cryptocurrency reached to all-time high of $19,783.06, now before understanding the valuation of Bitcoin, let’s discuss about currency. As per Investopedia, Currency is a generally accepted form of money, including coins and paper notes, which is issued by a government and circulated within an economy. A core characteristic of most modern currencies is that the material comprising the currency itself - the paper in a dollar bill, for example - is essentially worthless so that the whole of the currency's value is in its value as a medium of exchange. Now Digital currencies per say does not qualify to be called as Currency as per the technical framework and instead has many common characteristics to be called as Commodity. Recently Bank of Israel made a similar observation in Jan 2018 that "Bitcoin and similar virtual currencies are not a currency, and are not considered foreign currency." Moreover, “digital currencies should instead be viewed as a "financial asset" and that bitcoin does not fit the central bank's legal definition of currency.” So when used for trading of products, it’s not a trade using a currency backed by any government entity but just a barter trade of two commodities based on the value of the asset(Bitcoin) at the time of trade, which at the end is highly volatile due to qualitative factors of market preferences.

Valuation of Digital Currency is not easy when compared with the valuation of a stock or other Assets, generally value of an asset is based on present value of the future cash flows expected to be received from the asset, like for Stocks the value is based on the present value of future dividend and appreciation in the price of the stock. Similarly, in case of Machinery, the value is based on the benefits that are expected to be received in future, meaning there is an engine of value creation in these assets but in the case of commodities the case is different, the value of commodity to a much extent depends on the current utilization scale of the commodity, its value is based on the utilization capacity of value addition that the particular commodity can do for a specific need, which is highly biased on the belief system and information in the market. You must have heard of Guar gum(guaran), it’s a Gum made from the seeds of Guar, due to its chemical properties in recent years it was found that it can be used in Hydraulic fracking for Shale oil and many other applications. Due to its link with Crude oil and a new industrial application pushed its prices in last 5-7 years to a new level and even qualified to be on MCX exchange as well.

Every time when we transact, it’s a negotiation. Negotiations are not limited only to utilization scale, instead are highly biased due to individual preferences and desires, the interest/demand of commodities are highly influenced by behavioural biasness. The recent peak valuation of Bitcoin was a classic case of FOMO (Fear Of Missing Out), as per Wikipedia FOMO is "a pervasive apprehension that others might be having rewarding experiences from which one is absent". This social anxiety is characterized by "a desire to stay continually connected with what others are doing”. Everyone joins the buying rush as he or she is highly motivated by the group behaviour of buying, so in case of Bitcoin there was a cyclic buying which was raising the prices up and by looking at the prices, traders bought more due to the fear of missing out the bullish ride without realizing that the bullish trend was itself an outcome of previous purchase.

Let’s discuss the basics, you buy a meal in a restaurant for a specific price because you feel it is of worth spending. But there are ways where consumer choices can be manipulated by fooling your cognitive notion. There was a time when Chowmein was in fashion and so was the price, please focus on the term fashion here, the satisfaction of hunger from one plate of Chowmein for an individual should be the same for two different years 2012 and 2018 as the volume and content on the plate is not changing, but it doesn’t happen in real life due to preferences and behaviour biasness. Therefore, commodities’ valuation is suffered by fashion factor, as fashion dilute the demand goes down bringing the prices down.

Value of assets are combination of present worth and present value of future benefits, those assets which have substantial reason to define present worth and an engine to generate future cash flows will have justified valuation and are more stable but those assets whose values are based on fashion and shallow reasons are infected with high level of biasness and hence are not valued properly with a possibility of high level of price volatility.

Ashish Vazirani


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