Gold: understanding the difference between price and value

  • To understand how gold is valued by investors.
  • To list different ways in which investors can access gold.
  • To learn about the risks involved with certain ways of accesisng gold.
Gold: understanding the difference between price and value

Gold has for millennia been viewed as a form of currency. But while the price of the shiny yellow metal is very transparent, the true value of gold is still being widely debated.

Investors either love or loathe gold. Those who adore the metal highlight the fact that there is very little in circulation, it is very hard to produce as there is a finite resource in the world, pure gold does not tarnish or rust over time, and that it remains as a form of currency.

While government printing presses around the world have been flooding their economies with cheap money, gold cannot be mass produced at the touch of a button. For many, it is the ultimate currency whose value cannot be manipulated and offers an inflation hedge. 

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Those that distrust the metal point to the fact that it is simply an inert metal which, apart from looking appealing when buffed up, serves little real purpose. Unlike silver, where 50 per cent of the produced metal is actually used in manufacturing, gold is never used up.

Valuing the metal

There are two methods in valuing assets. The multiple method uses the cash flow or profits generated by an instrument to determine the overall value of the asset.

The replacement cost method values assets by calculating how much the asset costs to produce. Since gold does not produce an income stream or any cash flows, its value is determined by the cost of extraction.

This varies according to each different mine as the ease of extraction then sale differs significantly.

There are three ways of getting gold exposure: directly, indirectly and through a form of hybrid.

1) Getting direct physical exposure

The simplest way is to go out and purchase the physical bullion by going to a jeweller and buying gold sovereigns such as Krugerrands. These then need to be stored securely.

A more liquid and scalable alternative is to buy an exchange-traded commodity fund (ETC) which track the gold price.  There are two types: the physical ETC, where the ETC has full exposure to the physical bullion, or there is the synthetic ETC which uses derivative contracts (like futures, options, or swap notes and so on) to track the gold spot price.

Armageddon investors, those who invest in gold as they believe that capitalism is on the brink of collapse, will prefer to buy the tangible physical ETC.

As investors purchase new units, the ETC provider compliments the net trade (after the sellers have been accounted for) by buying then storing new gold bars in its vault. At any time the holders of the ETC will have full direct exposure to the physical gold.

As a result the share price for the physical ETC closely tracks the spot gold price. The fees of 0.4 per cent to 0.6 per cent are based on the cost of storage.