Commodity Valuation
The process of deriving the intrinsic value of a commodity under optimal market conditions
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What is Commodity Valuation?
Commodity valuation is the process of deriving the intrinsic value of a commodity under optimal market conditions. In a perfectly competitive free market, the price of a commodity reflects the intrinsic value of that good. Commodity valuation follows the classical economic principle of arriving at a price by studying the intersection of the demand and supply curves of a good, which is also called the break-even point.
Summary
- Commodity valuation is the process of deriving the intrinsic value of a commodity under optimal market conditions.
- Commodity valuation follows the classical economic principle of arriving at a price by studying the intersection of the demand and supply curves of a good, which is also called the break-even point.
- Since commodity markets rely largely on demand and supply patterns, anticipating future price movements of said commodities is the only way an investor can profit off of speculation.
Pricing Methods
Since commodity markets rely largely on demand and supply patterns, anticipating future price movements of said commodities is the only way an investor can profit from speculation. A majority of the investments in the commodity markets are through future contracts. They are derivative instruments wherein the holders are obligated to buy or sell a specified product at a set price and future date. Here, commodity prices are negotiated pre-facto, i.e., before the delivery of the goods in question.
Therefore, while negotiating the price for a particular commodity, there is a huge risk involved as the spot price or real market price may not be equal to the price as per the contract. The buyer may be secured against adverse price movements due to the seller’s obligation to fulfill the terms of the contract. However, the seller may lose out in case of a positive price movement in the future. Below are several ways to determine the price of a commodity:
1. Fixed Price
In the fixed price method, the price of the commodity on the delivery date is pre-decided. It means that regardless of the real market value or spot price of the commodity at the delivery date, both parties are contractually obligated to trade at the fixed price.
The practice ensures that both parties are protected against negative price movements but limits the return in case of positive price movements. In certain cases, the concerned parties may also consent to a periodic revision of the fixed price.
2. Floor and Ceiling Price
In the floor and ceiling price method, a ceiling is set for the maximum (ceiling price) and minimum (floor price) possible price of the product. The price window provides flexibility to both parties.
If the market price on the delivery date falls within the window, then that spot price becomes the price. Contrarily, if there is a large price movement, both parties are able to enjoy higher profits.
3. Floating Price
In the floating price method, the price of the commodity is settled by monitoring price movements for a prolonged period of time and then averaging available data to arrive at a price. The floating-price method is more suitable for long-term contracts in volatile markets. It provides some security to both parties as sudden fluctuations get evened out.
Commodity Valuation – Process
The process of valuing a commodities company includes “normalizing” its earnings. It means to average a company’s cash flow over time to cover a typical economic cycle. Normalizing enables investors to understand the revenue, earnings, and cash flow of a company. It can be done either by calculating the average price of a commodity, after adjusting for inflation or by arriving at the fair market price or spot price after examining demand and supply.
An alternative for the same is to study futures markets and use market-based prices to estimate the future cash flows of a company. It is preferred by analysts as it is implicitly risk-assured due to a built-in hedging mechanism. An investor worried about the performance of a company can purchase futures and artificially drive the price of the same.
Additional Resources
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
