This article is going to be half-column, half-survey, because I genuinely don’t know the answer to the question I’m about to propose to you, the reader: How do you place a numerical value on a given stock in Second Life? 

In real life, there are extensive tomes written about this question.  Answers vary from the simple and easy-to-understand to complex formulae that require specialty software to calculate (or a doctorate in Mathematics).  However, in Second Life, no such guidance exists.  There are certain rules of thumb, so to speak, such as not investing in anything you cannot understand, and not investing any more than you’re willing to lose.  There are some calculations that can be done with the statistics provided from financial reports, such as NAV (Net Asset Value), P/E (Price divided by Earnings), and dividend yield (dividend over a certain period of time divided by the stock price).  Overall, though, there is very little analytical guidance to be found.

I thought it might be insightful to try out one of the real-world mathematical models to some Second Life securities and see how they perform.  Beware that this is in no way a complete statistical analysis and my sampling methods are haphazard at best. 

The Gordon Growth Model (or Dividend Discount Model) allows investors to take a stock’s current dividend, the current interest rate, and the expected growth rate of the stock’s dividend, and compute a share price from those values.  While the derivation is somewhat complex, the end result is a compact little formula, which is expressed as D₁/(k-g) = P, where D₁ is the dividend in time period 1, k is the interest rate demanded by the market, and g is the expected growth rate of the stock.

Using a monthly interest rate determined by SLCapEx’s current daily rate (0.10% per day), k = .03044.  I will make a further simplifying assumption that g = 0, because we don’t have much data in the realm of dividends to determine a growth rate.  I will summarize my findings in the table below:

 So as you can see, there’s not much of a conclusion to be drawn here.  Some of this can be blamed because I’ve taken the growth rate component out of the formula.  I suspect a full-out statistical study would be inconclusive, but that’s just a hunch.

My fear and suspicion is that many investors use the “greater fool” theory of investing. The idea is that you will buy a stock only because you think someone else will buy it from you later at a higher price.  That’s it.  No numbers, no studying the company, just the idea that the price will rise.

A fair number of investors also use value investing , as well. This method looks for undervalued companies and holds them until they reach a more appropriate value for the market, at which point the investor sells.  This is the method used by some of the most famous investors in First Life, such as Warren Buffett.  There is no numerical model for value investing, like the greater fool theory.  However, with value investing, an investor will seriously study the company before deciding to purchase.  The easiest way to tell a value investor from a greater fool investor is to quiz them about the company: a greater fool investor won’t be able to tell you much more than the ticker and price, but a value investor could give a lengthy speech almost impromptu.

So, readers, how do you value the stocks you buy (if you buy)? Formulas?  Price history?  Trends? Dividends? Announcements? Chats with the CEO? Dice? Psuedo-Random Number Generators?  I look forward to your insights.

GM

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Kay Noble - Great!     | 2007-11-18 23:18:20 Great, at least someone who knows about stock markets and the valuation of firms. Indeed, it is difficult to set a value for g, but zero is rather "low". Hopefully the growth of the firms in SL will at least be equal or superior to inflation. On my side, i am looking first how much money the entrepreneur has put in the venture, since how long is "playing", and if the product or service fill a market gap. Quote 0   0

Vitall Beck - Gordon's model not the best ch   | 2007-11-19 10:20:36 Gordon's valuation model is applicable only for stocks with a well understood and stable dividend/growth history. In SL, the growth/dividend history even for most mature public companies is far too short, and future growth/divedends too hard to predict. This model explicitly accounts for a trade-off between distributing the earnings (in form of dividends) and reinvesting them to keep the business growing. In this context, disposing of growth rate altogether as per your suggestion makes no sense, as the model will produce rubbish results. With zero growth assumption, in order for the formula to be at least somewhat useful, you should use Earnings instead of Dividends. Another problem would be with the required rate of return for the stock (NOT "interest rate" as you put it). According to the theory, this rate should reflect the risk level specific to this PARTICULAR stock. Interest rate of SLCapex trader's deposits is not a good substitute here, as it reflects only the systemic risks of this exchange, and greatly underestimates the specific risks of the particular stock. (As a counter-example, the deposit rate on VSTEX is zero - should the same stock listed on SLCapex and VSTEX have VERY different valuations?!) IMHO, any sort of dividend-discount model will work poorly in SL because the appropriate discount rate is very hard to determine. For example, in SL there is no such thing as a "risk-free rate of return" which is essential for CAPM and similar models. So, ultimately a stock valuation in SL should be an example in value investing - good old Warren Buffet way. Try to limit the risk by investigating the company (its CEO, ultimately - this is your major risk factor). Try to understand the company's business, its position in given market segment, its growth and profitability perspective. Some fundamental analysis would not hurt - compare ratios like P/E, Price/Dividends, growth rates, profit margins to similar companies. Only invest if you're comfortable with the risk level and ready to hold to this stock for a reasonable time (no guarantee that you'll be able to liquidate your position fast - the liquidity in SL exchanges really sucks). Quote 0   0

Guardian Market   | 2007-11-19 18:30:00 Very good points about the shortcomings of the Gordon model, Vitall, and I was aware of a few of them. Do you think there is another mathematical model that shows some possibility of functioning here in SL? Quote 0   0

Vitall Beck - SL stocks valuation   | 2007-11-20 06:01:52 I don't think that applying RL valuation models to SL stocks will produce meaningful results. RL valuation models were developed based on specific assumptions, which in general do not hold for SL. I've already mentioned lack of risk-free asset equivalent in SL (how could there be one - even Linden Dollar itself is nothing more than a "game token" according to Linden Lanbs and most so called "SL stock exchanges"?) Another assumption of RL valuation is a certain level of business continuity. In RL, the public company usually does not disappear if its CEO is "too bored to continue", has "some RL problems" or worse, liquidates all the assets and runs away with all the "game tokens" in his possession. In RL, even in the last case there are ways to ensure and enforce continuity, and this is reflected in stock valuations. It is a very different story in SL... Essentially, you can approach any SL stock purchase(or BOND, or SL Bank Deposit for that matter) as a personal loan to CEO without any collateral, liquidation value or even payout guarantee (as the recent Hope Capital Bond debacle so clearly demonstrates). Yes, there are ways to assess the risk level and put a value (rather, the probability-weighted expected return) on such "assets" - statistical methods for example. However, such exercise has almost nothing to do with RL stock valuation models. Quote 0   0

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