Foreword
In this blog, we talk a lot about “value” — intrinsic value, extrinsic value, productive value, etc. What does it mean exactly, though, what is value? In this post, I try to put a definition on what I mean by “value”.
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
My values
We’ve discussed in multiple prior posts about this amorphous thing called “value”, and at times, I’ve adorned it with a prefix like “intrinsic value” or “extrinsic value”, but I’ve never really defined what these mean.
The idea of “value” is ill-defined in finance, and in many cases, is simply synonymous to “price” — for example, in some states, the value of your home on which your property taxes are based, is simply the price you bought the home at, and the value of your stocks portfolio is generally defined to be the sum of the last traded price of each asset.
But in economics and finance, sometimes there is a distinction made between price and value, yet value is very often not clearly defined — certainly, if you ask 10 different economists/financial observers, you’ll likely get 11 different definitions of “value”.
So, here to make things clearer (or murkier?), I’m putting forth my own definitions of value, of which there are 4. Yes — ask 1 single JB, you’ll likely get 4 different definitions of “value”.
Intrinsic value
Intrinsic value is the value something has, because someone wants it for the thing itself. For example, a piece of bread has intrinsic value — it sustains life and affords temporary reprieve from hunger.
Extrinsic value
Extrinsic value is the value something has, because others prescribe it value beyond its intrinsic value. For example, a dollar note has very little intrinsic value — if you are desperate, you can burn it for a few seconds of heat, but that’s about it. However, a dollar has exactly one dollar of extrinsic value, because others are willing to trade you things of value for your dollar.
Productive value
Productive value is the value something has because it is able to produce other things of value. For example, a well run, profitable business has productive value — it produces goods and/or services that are valuable and which can be exchanged or sold for other things of value.
Speculative value
Speculative value is the value something has that is above and beyond all the values above. It is generally the value someone, including yourself, may ascribe to something, simply because that someone think yet another someone else may value the thing at some value beyond the values above.
Breakfast at the beach
Let’s say you are on a deserted island with no food. For whatever reasons, you have infinite dollars with you. What would you pay for a slice of bread at that very moment?
Given that the island has no other sources of food, the amount you would be willing to pay, would be somewhat commensurate with how hungry you are (time difference between now and the last time you bought bread) and how long you think rescue will come. Therefore, the intrinsic value of that slice of bread increases with time, until you buy it, at which point, it’ll drop slightly as you are sated, but start growing in value again until the next time you are hungry. It would be entirely conceivable, for you to pay $1m or even more for that slice of bread in this situation.
If, however, you are in the middle of Manhattan, with all its wonderful choices attending to all kinds of appetites, a slice of bread would very properly drop in value, to almost nothing.
So, on the deserted island, the extrinsic value of money dropped significantly, because there simply isn’t any other merchants for you to spend your money. But in Manhattan, the extrinsic value of money grew comparatively, because you are spoiled for choice.
In the opposite way, the intrinsic value of bread increases to almost infinity as you are starved for food on a deserted island, but drops to almost nothing when you are in Manhattan, surrounded by much more choices of food.
As with intrinsic value, productive value, being a derivative of the other types of value, will, too change based on the circumstances. Back on that deserted island, a magic machine that produces a slice of bread a day would be worth fortunes — you may even be tempted to give up your entire infinite wealth. But in Manhattan, most would barely pay a few hundred dollars for it.
Buffett value
Warren Buffett is often cited as having said
Price is what you pay. Value is what you get.
Warren Buffett
To put that in our value framework, “price” would be the money you hand over, i.e. the extrinsic value you give up, and “value” would be the things you get in return, the sum of the intrinsic, productive and speculative values.
While we’ve said that the exchange rates between intrinsic, productive and extrinsic values can change, the value of speculative value is entirely in the difference — If you paid $10 for something with $1 intrinsic value and $2 productive value, then you must have paid 10 – 1 – 2 = $7 speculative value for it.
Unlike the changes in intrinsic and productive values under different circumstances as we’ve discussed above, changes in speculative value are almost entirely based on changes in mindset and sentiments. It is changes in speculative value, when a stock trades $100 one moment, and $101 the next, absent any relevant news.
And that difference is key. While intrinsic, extrinsic and productive values rarely change dramatically from minute to minute or even day to day, speculative value can and do change almost continuously. If someone bought a stock at $100, someone else may see the trade and think “what do they know? I should buy at $101!”, and yet someone else may see the trade and think “what does the seller know? I should sell at $99!”.
This uncertainty, this second guessing, this random flights of fancy and random depths of despair, they are what drives speculative value, and because the reasons for changes in speculative value is so fickle and the results so extreme, it is rarely a good thing to rely solely on speculative value when you are trading assets.
Net worth
It is with this in mind that a well thought out financial plan should include some cash buffer and sources of cash flow (dividend stocks, bonds, etc.). Because while it is generally true that non-dividend paying stocks tend to increase in value faster over time, if your entire portfolio is in non-cash and non-cashflowing assets, then you will always be subject to the whims of speculative value — to the whims of how much others feel they should pay you for your assets.
And remember, you cannot eat net worth. Especially if it is ephemeral, and the market simply ascribes lower (or even negative!) speculative value to your assets right now.
StockClubs
As you may have heard from prior posts, I am an investor in StockClubs, an app which lets you share your portfolio (or part of it) with others. While it is still in heavy development, the team would greatly appreciate any feedback!
Janky Thoughts 