Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

QUESTION AND ANSWER SESSION

Question: How do you tell when gold is overvalued?

McLennan: We own gold as a potential source of ballast and do not take a directional view, so the under- or overvaluation of gold is not our primary concern. For us, the value of gold is essentially on a continuum that is inversely related to confidence in the system. Investors can calibrate the value of gold by looking at it in an opportunity cost context.

If gold is a potential hedge against monetary calamity, then people should be willing to pay for that hedge over time based on their per capita income levels and the value of their assets. They will pay a certain amount for that hedge depending on what they perceive to be the need for a hedge. We have observed that when real interest rates are low and/or the creditworthiness and credibility of a government is low, the value of gold tends to be higher than average.

Question: What is the current economy saying about the value of gold?

McLennan: The self-healing mechanism of the economy may already be in place at this point in 2010. Corporations are generating free cash flow, which has typically led to better employment and confidence trends and, in turn, to a self-sustaining recovery. If that happens, real interest rates and budget deficits will normalize at some point and the price of gold could go down. In fact, that would be the preferred scenario because equities that embody a margin of safety in price could do just fine in that better state of ...