The Model Thinker #20 : Spatial and Hedonic Choice models

This article is a more detailed way to look at the statement that "Price is what you pay, value is what you get."

What models exist to explain the value of a good ?

Spatial attributes have no best value. One example of a spacial attribute is thickness of a slice of bread or the colour of a jacket. Preference depends on the individual. In the financial world, the optimal amount of the debt/equity ratio is around 30-40% and varies from industry to industry. Picking out stocks with the lowest or highest debt to equity ratio result in substandard performance.

Hedonic attributes are values whereby the higher than better. An example is your PSLE t-score, why would anyone prefer 240 when he can get 270. In the finance world, I would reason that free cash flow yield is a hedonic attribute. A portfolio of stocks with the highest decile of FCF yield will almost always perform better than a portfolio with a lower decile.

When it comes to valuation there are other models.

A coordination model is where prices are socially constructed. The example from the book is Art. The value of a Jeff Koons sculpture is ultimately based on the good will and distribution of values ascribed by many individuals. It is highly dangerous to make investment bets on something that has a price that is socially constructed. One day it would be high. Another day, no one will even pay a pittance for it.

Finally, something may have a value that depends on how much a person in the future will pay for it. This is based on predictive modelling. The price of Bitcoin depends on how much people are willing to pay for it in the future.

The models can be used in isolation or in combination.

The books uses examples from political science, but it might be able to qualitatively explain the valuation of securities.