Fundamental Value

All through this section of the blog I’ve been claiming that asset prices are “inflated”.  This means that assets are selling for more than they are actually worth, which in turn implies there is a “fundamental value” of an asset that determines that worth.

The concept that assets have a “fundamental” or “intrinsic” value is not controversial – it is routinely and widely accepted by economists who study finance.  The idea that this value is not determined by financial markets would in the past have been highly controversial – indeed, heretical.  But before we consider the latter point, we need to understand what determines fundamental value, and I’m going to start by looking at the value of fixed capital itself.

Fixed capital is the purchase of goods that are used in the production process over long periods of time, such as factories and machines.  It is by far the largest component of investment expenditure (the other component being increases in inventory).

When a business purchases fixed capital it anticipates recouping that cost over the life of the asset through the additional profits made, and making a higher profit as a result of purchasing this asset than could have been made through using these funds in other ways.  Hence, the fundamental value of fixed capital is determined by the expected value of what it will produce in the future – it is entirely connected to its future productivity.

And as the fixed capital is by far the largest component of investment expenditure, the value of investment, and therefore the value of national saving, is also entirely connected to future productivity.

The same logic applies to financial assets, but in an indirect way.  There is no asset that is directly tied to the performance of the specific fixed capital that it funds.

The closest we get to this is buying shares.  The return a saver will make on share ownership (in dividends and share price) depends entirely on the performance of that company.  The “fundamental value” of that share, therefore, depends on the future productivity of that company and its capacity to make money in the future.  However, this capacity also depends on what happens in the rest of the market.  A business might be investing in fixed capital that will enable it to produce its goods far more efficiently, but if those goods are going to be be superseded by other products, for example, that increased productivity will not be reflected in increased profits.

The value of corporate bonds are not tied to the performance of the company at all.  Bonds typically guarantee a regular (often 6-monthly) payment known as a coupon, that represents an interest payment, and then the repayment of the full value of the bond at a specific future date.  The bond-holder knows exactly how much money they will receive in purely monetary terms, and they receive this regardless of company performance, unless the business in question actually goes bankrupt.  The risk in this case is that they don’t know what this monetary return will be worth in real terms.  Above expected inflation or interest rates will reduce the real value of that bond.

So it is slightly harder to see the connection of fixed-income securities to the performance of fixed capital.  The value of the assets depends on the rate of inflation and on competing interest rates, and these in turn depend on the performance of the economy, which depends on productivity, which depends on fixed capital investment.  The link to productivity and investment is still there, but indirect and harder to see, and relates to the economy as a whole, not the performance of the bond-issuing company.

The fundamental value of bonds, therefore, is determined by their expected performance relative to other assets, including shares.

But note the word “expected”.  When a business estimates the value of fixed capital investment it can never know for certain what the future value of production will be.  A saver buying shares cannot know for certain how that company will perform in future markets.  They don’t know, for example, whether new competition for that product will emerge, or whether consumer tastes will change.  They don’t know if an economic downturn will reduce demand in general, and if so, whether that business will fare better or worse relative to other products.  And if they buy bonds, they cannot possibly have any certainty about the future inflation and interest rates that determine the fundamental value of that bond.

Prices are set based on the expectations of those trading in the market, expectations that can, and will, be wrong.

In this world of uncertainty, people have different attitudes to risk and therefore will value assets differently.  Those who want to ensure a safe and stable return will not want to invest in risky assets and will value them less, while others will want to take risks for the chance of higher rewards, and therefore will value risky assets more.  Attitude to risk is therefore a major factor in the desirability of different types of assets to different types of investors, and reflected in prices.

But if we could be certain about the future performance of companies then the question of tolerance to risk would not arise: the price of shares would be based simply on the known future earnings of that company.  Similarly, if we knew what inflation and interest rates will be in the future this would determine the price of bonds.  This is the fundamental value of these assets.

Of course, such certainty is inconceivable, and hence assets are priced according to the traders’ estimations of the company’s or the economy’s future performance (in relation to their attitude to risk and reward).  If these estimations are wrong the trader will pay the wrong price for the asset – they may pay too much or too little (in the latter case, it’s more natural to think of it as the seller being willing to sell for too little because of their own flawed estimate of the asset’s worth).

In this section of the blog I have repeatedly been arguing that increased individual saving inflates the price of assets away from their fundamental value without contributing to national saving (i.e. investment).  There is an economic theory called the Efficient Markets Hypothesis that, in its strong form, says that the market will always get the price of assets right – they will not veer widely from their fundamental value.  That, in fact, the market price tells us the fundamental value of the asset because markets process information far more efficiently than any individual can.  As this is the complete opposite of what I’m saying it is worth considering this position, which we will do next week.

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