Commodity Valuation: Understanding Intrinsic Value & Market Pricing

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 pointBreak-even Point (BEP)Break-even point (BEP) is a term in accounting that refers to the situation where a company's revenues and expenses were equal within a specific accounting period. It means that there were no net profits or no net losses for the company - it "broke even". BEP may also refer to the revenues that are needed to be reached in order to compensate for the expenses incurred.

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 supplySupply and DemandThe laws of supply and demand are microeconomic concepts that state that in efficient markets, the quantity supplied of a good and quantity patterns, anticipating future price movements of said commodities is the only way an investor can profit off of speculation. A majority of the investments in the commodity markets is 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 priceSpot PriceThe spot price is the current market price of a security, currency, or commodity available to be bought/sold for immediate settlement. In other words, it is the price at which the sellers and buyers value an asset right now. 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 inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money). 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)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! 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:

• Arbitrage Pricing TheoryArbitrage Pricing TheoryThe Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s returns can be forecasted with the linear relationship of an
• Commodity Linked SecuritiesCommodity Linked SecuritiesCommodity linked securities are investment instruments or securities that are linked to one or more commodity prices. Unlike commodities, which provide no income to the owner, commodity linked securities usually give some payout to holders.
• Types of MarketTypes of Markets - Dealers, Brokers, ExchangesMarkets include brokers, dealers, and exchange markets. Each market operates under different trading mechanisms, which affect liquidity and control. The different types of markets allow for different trading characteristics, outlined in this guide
• Guide to Commodity TradingGuide to Commodity Trading SecretsSuccessful commodity traders know the commodity trading secrets and distinguish between trading different types of financial markets. Trading commodities is different from trading stocks.