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Why are Rough and Polished Prices Disconnected?
In the diamond industry, we often hear that the cost of rough diamonds is disconnected from the price of polished diamonds. Many of us wonder how that is possible, especially since the largest cost component of polished diamonds is rough.
According to diamond industrialist Ehud Arye Laniado, the only way to determine the value of rough diamonds is by the value of the polished diamond outcome from that rough diamond, minus the manufacturing costs and profit. Why start from the price of polished diamonds? Because the power to set the price of polished diamonds is in the hands of consumers. The average price consumers pay for a particular polished diamond sets its value, and from that, we derive the cost of rough diamonds using a reverse engineering calculation.
Valuation discrepancies
One rough diamond has all manner of potential uses. Different buyers and different manufacturers see different possibilities for polished output from the same rough. Each may see a different outcome, and therefore different polished diamonds manufactured from it.
The desire of the buyer to manufacture the goods is not the only factor that determines the wide range of prices paid for rough. Traders also have an impact: they consider the resale price they can achieve from trading the rough diamond in the market, almost regardless of the polished outcome potential.
Buyers lacking wide knowledge and experience, the needed capital, or simply access to good stock, may pay a high price for a rough diamond. This reality reflects the high premium on the original price, and, at the same time, a disconnect from the price they can get from the polished diamond outcome. This is because rough diamonds can be abstract and open to differing views.
A case in point: two valuators may assess several parameters of the same diamond differently. For example, they may assess color one step higher or lower, or determine the achievable clarity of the manufactured polished diamond differently. They may even disagree on the size of the resulting polished diamond. A single color or clarity step difference, and a slightly heavier polished diamond, may result in as much as a 60 percent difference in value – from the very same rough diamond! Let's say one valuator expects a 2-carat polished diamond from a 5-carat rough, and another valuator sees two 1.5-carat polished diamonds in the same 5-carat rough. That discrepancy would be enough to create a 50 percent price difference.
Since the gaps can be so wide, and each valuator is convinced of his or her assessment, the wide range of interpretations of each rough diamond, plus the possible mistakes, errors and miscalculations involved, can result in rough diamond purchases at odds with the achievable price of its polished result. Further, they can even result in different polished diamond outcomes that can be sold a different prices.
This is but the beginning of a series of decisions that separates the cost of a rough diamond from the price of the polished diamonds manufactured from it. This subjectivity leads at times to over and undervaluation of rough. It is also what sometimes leads to the wide differences in bids at tenders.
And so, slowly but surely, the only fundamental principle of how to determine the cost of rough diamonds is lost, and the reverse engineering methodology described above is left by the wayside by the different valuators in favor of other valuation methods.
Further valuation discrepancies
Comparing prices of similar-looking rough diamonds is another common approach to assessing value among some valuators. Rough diamonds that look the same get the same price. Is this a correct approach?
Above, we looked at a case where a 5-carat rough diamond could be assessed by one valuator to yield a single polished stone, and assessed by another to yield two polished diamonds. To complicate matters further, imagine what happens when a valuator examines two similar-looking but different rough diamonds. He may think that they have the same value, because he expects them to have the same polished output. However, if the polished diamond manufactured from one rough diamond has a single step difference in color and clarity, the two "identical" rough diamonds should be valuated very differently. The reason is that the value of the polished output of one rough is almost double that of the other.
This example can happen in many different rough diamond sizes. For example, two 1.5-carat rough stones can have the following two very different outcomes. One rough stone can result in one 0.50-carat and one 0.30-carat polished diamond, while the other results in a 0.40-carat diamond and a 0.25-carat diamond of lower color and clarity. In this case, the value of the second 1.5-carat rough stone should be about half as much as the first rough diamond.
Incorrect valuations can have a devastating economic impact. If a diamond is over-valuated at a tender, the manufacturer could lose money, because the price of the resulting polished is low compared to the cost of the rough. Undervaluation at a tender can also be hurtful because the rough diamond might go to a higher bidder who assessed the diamond correctly.
Thus, all of these errors, miscalculations, misassessments and lack of knowledge have led to a disconnect between the cost of rough diamonds and the transaction price of polished diamonds.
This disconnect leads to lack of credibility in the eyes of bankers, who may feel the value of an inventory is wrong. The result is a hesitance to finance new rough diamond purchases. This misassessment of values complicates valuations of inventories for profit and loss accounting. And above all of this looms the issue of a fairly rigid primary rough diamond market with a speculative secondary market that has varying premiums, with all the problems that encompasses.
The outcome is worrisome: a market where many buyers don't examine in depth the rough (and at times don't examine it at all). Most prefer to buy a brand from certain producers according to varying valuation methodologies, and add a premium that changes according to traders' moods, without any direct correlation to the value of the diamonds that will be polished from them.
That is why Ehud Laniado developed a system that should be adopted by every part of the diamond industry that deals with rough diamonds. The equation is simple, and every player in the industry should remember it by heart:
If rough diamonds are valuated correctly – and experience proves time and again that Ehud Laniado's formula works – then the wide discrepancies in the valuation of rough diamonds can be dramatically reduced. We have knowledge accumulated over generations and great expertise. We must harness this and learn how to continuously improve. Using this professional know-how in combination with my methodology could bring greater financial success to the diamond pipeline, mostly to anyone who deals with rough diamonds as part of their daily diamond activity. Doing so will increase our capital, improve our ability to find bank financing, and result in a much healthier business environment that will allow us to extend our trade into other areas.
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