The flagship product of my reports is something that I call my “Coffee Valuation Score.” The purpose of this report is to provide a cents per pound valuation for coffee that is based on objective, quantifiable criteria. In other words, this report is a formulaic estimation of #coffee value.
Having an objective, cents per pound valuation for coffee is a useful tool for those of us in the market because it allows to make a judgement on whether coffee prices are over or undervalued.
In this article, I will share with you the underlying philosophy for how I have built this, as well as the basic framework for how it is constructed. It is my hope that this will be useful both for my clients, who receive this from me, and for friends within the coffee industry to build their own models of coffee value.
Let’s start with the philosophy. My philosophy on valuing coffee is based on a single, all-important concept.
This concept is quantification.
This concept goes back to my hedge fund days when I was very influenced by a book given to me by a friend and mentor.
The book was called “Superforecasters” and this book follows the story of a CIA experiment to find people who are talented at predicting the future. The CIA did indeed find these people, and they dubbed them “superforecasters” for their ability to predict the future above and beyond the ability of the crowd.
One of the key traits that these superforecasters had in common was that they all focused on numbers. It wasn’t enough to say that a revolution in Moldovia is likely to happen, a superforecaster predicted that there was 65% chance that a revolution in Moldovia would happen within 6 weeks.
The use of numbers allows us a level of precision, both in outlining our estimates of impact and also probability.
I adapted these twin metrics of impact and probability into my own forecasting and they form the backbone of my scorecard.
Let’s look at the structure of the scorecard and you will see how.
My scorecard is broken down into 6 components that each provide a c/lb valuation that affects coffee prices.
I then sum each of these cents/lb valuations together to get a total valuation for coffee prices.
There is some variation for each category, but in general I am evaluating a present value of current and likely future events. With the fundamentals for example, I use a stocks to use ratio to create a price model that outputs a c/lb value based on the current stocks to projected used. I then evaluate how stocks to use is likely to change over the next 6 months, and incorporate that price change into the present value.
Let’s look at weather to give a more clear example of how impact and probability can be incorporated into the score.
We know that at present, there is a possibility of a frost occurring in Brazil. What is the impact and the probability of a frost occurring?
The impact of a frost would be significant on the market, and we can quantify exactly what that impact could be by looking at past frosts and assessing min, maximum and average c/lb (or % c/lb) impacts on coffee prices. Perhaps we find in our research that a light frost has an impact of 10c and a major frost is likely to have an impact of 90c. Our average impact would then be 50c.
Given that we don’t have any particular frost in the forecast we could revert to the default and say that there is a 12% chance of a frost of some kind this winter. 12% of 50c would be 6c. Therefore we would add 6c to our valuation score.
If our other factors (Fundamentals, technicals, etc) valued coffee at 205c, then when we add the weather valuation to our total score we would get a valuation score of 211c.
However, what if the weather changes?
Let’s say we see a frost in the forecast to impact a large area with high degree of certainty. Perhaps large frosts have an impact of 50c on the low end and 90c on the high end. Our average would now be 70c, and perhaps our probability has increased to 60%. 60% of 70c would be 42c. Therefore I would add 42c to my valuation score. In the example above where the score was 205c, now the valuation score for coffee would be 247c.
If the odds decrease to 30%, I would decrease the score by 21c. So the new value would 226c.
Quantification is the core philosophy of how I keep track of my valuation score on a daily basis. This enables me to incorporate the latest market moving factors into an objective valuation that I can provide to my clients .
My value score often differs from the market's perception of value, and this is where the opportunity is. My value score makes it easy for my clients to compare the current price of coffee with our own shared understanding of its value. If the market is over or undervaluing a given factor, it can lead to a trading opportunity.
The other value to this practice is one of shared language and transparency. My clients can look at specific areas where we might disagree on impact, and then we can discuss why.
Perhaps my clients think that I’m too optimistic on my forecasts of coffee stocks, or they think that my estimation of weather is too negative. We then discuss these factors and either I adjust my score, or the client might make their own adjustments to my valuation.
The important feature here is that it enables us to be precise when we are talking about price expectations for coffee. Are we bullish? How bullish are we? What are the factors that will change that perception? How will weather patterns impact our forecasts? For me, the key to answering all of these questions is quantification. Using numbers in our methodology allows us to be precise in our estimations of impact and probability on the coffee market.