Continuing from our previous article, Difference between ?assets? and real assets, we will discuss two concepts that are often confused with each other- price and value.
Everyone knows about price. So, we will not talk more about it. But the trick question is: is the value of an asset based on its price? In accounting, the value of an accounting asset (as opposed to the definition of an asset that we mentioned in Difference between ?assets? and real assets) is based on price, whether historical price of some kind of derivative of market price. In today’s speculative mindset, the quality of our investing endeavours is often judged according to the price it can fetch on the market. For example, the 2007-2008 financial year was marked by abysmal ‘performance’ of the stock market, which implies abysmal performance of our superannuation funds. Basically, this means that the price of stocks have fallen. In this kind of herd mentality, it is often easy to associate price with value.
But as investors, we have to understand that there is a difference between price and value. The former is just an easily understood nominal number. Value, on the other hand, is a relative concept. The value of something implies its worth relative to something else. So, what is the value of an asset? As we explained before in Difference between ?assets? and real assets, an asset is something that
… puts money into your pocket periodically.
Therefore, the value of an asset is a measure of the worth of its cash flow relative to the cash flow of something else. What is the “something else” that an asset’s value is compared against? Well, it is the cash flow fetched by a long-term government bond. In other words, the cash flow of the long-term government bond is used as a yardstick for which we measure the value of an asset’s cash flow.
Government bonds are theoretically zero risk in nominal terms (not in real terms though) because it cannot default on its loan (well, not if the government happens to the Russian government in 1998) as it has the power of the monetary printing press.
The cash flow of an asset, on the other hand is full of risks compared to the long-term government bond. Behind an asset is always a business enterprise, which can fail in its ability to earn cash to its owners’ satisfaction- the business may even fail completely. Therefore, to compensate its owners of that higher risk, it has to earn a return higher than the risk-free government bond. The riskier the business enterprise is, the higher the rate of return should be demanded.
In the next article, we will explain what the return on an investment is. That will involve more mathematics.
