The 1,000%+ rise in the price of Bitcoin over the past year has garnered a great deal of attention recently, and probably undeservedly so, in my opinion. I am unaware of any products whose price has shot up so quickly without seeing a similar, subsequent sharp drop shortly after this dramatic rise. All we have to do is simply look at what history has presented us in the form of three other bubbles:
- The Dutch Tulip Mania bubble – 1630’s
- The dot-com bubble – 2000
- The U.S. housing market bubble – 2008
All of them share the same characteristic in the sense that consumer behavior acted irrationally – assuming the price of the given asset would not fall, resulting in paying ridiculous premiums for something that did not hold such value. In other words, market participants were speculating (that is without sufficient reason or the slightest bit of logic) that the given asset would continue to be worth more in the future than today.
This blog will attempt to place a real value on the price of a Bitcoin using a variety of valuation methods and then I will leave it up to the reader to determine afterwards what they believe Bitcoin’s true value is. To be clear, I’m not discrediting the creators of Bitcoin nor the inventors of blockchain. In fact, I believe block chain technology has the ability to disrupt the way we conduct transactions. I am also not inferring all other cryptocurrencies fall into the same category as Bitcoin, only the majority of them. Some of them actually provide real value, but that will be for another blog. It is the fact people have placed an absurdly high value on a product, which by the way is not even tangible, and yet continue to flock to it like a moths to a flame.
If you are new to understanding blockchain, cryptocurrencies, Bitcoin, distributed ledgers, etc., read my previous primer on the topic to help get your minds wrapped around what we’re going to talk about in the following paragraphs.
Let’s try to apply some commonly used asset valuation techniques to uncover what a Bitcoin might be worth. We’ll be exploring:
- Intrinsic Value – a metric widely used by the investing world
- Store of Value – one of the criteria used by economists to determine whether something may be classified as money, since, after all, the underlying premise of Bitcoin is to be able to spend it and if you can’t spend it, what’s it worth?
- Cost of Substitution – used widely in the energy business where multiple products can be used to generate electricity (like coal vs. natural gas). We’ll look at competing products who serve virtually the same purpose as Bitcoin and can easily substitute for it.
- The Common Sense Method – at the end of the day, what can a Bitcoin physically be used for?
What is intrinsic value? According to the world’s most famous billionaire investor, Warren Buffett, it is: the discounted value of future free cash flows from a business over its lifetime.
How does a Bitcoin generate cash flow? Via the fees charged on every transaction. Though Bitcoin.org says transaction fees may be zero, this will not be the case going forward. Why? As the blockchain continues to grow (new transactions verified and added), it becomes increasingly difficult in terms of computing power to verify and add the next block, resulting in longer transaction times. In order to compete with other cryptocurrencies and encourage faster transaction processing times, fees will eventually rise as more resources (ie. computing power) is needed to verify and add blocks to the blockchain. At the same time though, with rising costs will come substitution which we’ll get to later in on this blog.
The rise in transaction fees can already be seen from the chart below (from bitinfocharts.com) where the transaction fee has been hovering around $5 but has recently spiked to $20.
Given the $20 transaction fee, I’ve calculated the NPV of each Bitcoin over a 10-year lifespan under the following assumptions:
- Transaction fees stay flat at current rates OR move slightly higher to $25
- Discount rate of 5% (which is generous in this current economic environment)
- 17 million Bitcoins created in total
Here it is again in chart form:
The takeaway from these charts is that only under the assumption Bitcoin acceptance grows 50% per year would the current market price be valid. This is a big question mark and given the competition, it’s difficult to say with any certainty that will be the case. Though the number of transactions with Bitcoin has increased over the past few years, it’s growth has not even rivaled that of its nearest competitor. As a result, I would place Bitcoin’s intrinsic value today at between $1,427 to $6,000 at most. Later in the blog I will get into why I don’t believe the higher price target of $23,000 is justified and why ultimately, we should question Bitcoin’s intrinsic value altogether.
Store of Value
Money has a store of value. In ancient times we used silver and gold coins to trade for goods. Why? They were seen as decorative, did not tarnish and therefore always retained a store of value because of human desire to own such pieces. Other commodities like oil, gas, cows, wheat, corn, etc. have a store of value because humans require these items to survive. Oil is refined into gasoline to power our cars. Gas is burned to heat our homes and cook our food. Cows, wheat and corn are all consumable items needed for calorific intake.
The U.S. dollar (a.k.a. Fiat Money) has a store of value equivalent to the number on the bill. Though this is only a piece of paper, its value is backed by the guarantee of the American government with the “This note is legal tender for all debts, public and private” note in the bottom left corner. Although it is Fiat Money and is as only as good as the government’s guarantee, the chances of complete dissolution of the U.S. Government is near 0 and even if it did happen, at least you can burn the paper for heat or even wipe your ass with it (the Common Sense method).
Bitcoin, on the other hand, does not hold a store of value. Why? The price volatility in Bitcoin is unprecedentedly high. Extreme volatility in its price makes it difficult for people to trust, store and use the currency as they are not confident which direction price will go. Although Bitcoin futures were recently launched on the CBOE, hedging price risk on an exchange by any retail investor requires technical know-how and sufficient capital (as a Bitcoin contract is worth $17,000 at time of writing) to manage their positions. It was reported some brokerages who are allowing trading of Bitcoin futures will limit customers’ ability to short the cryptocurrency due to “extreme volatility”. If you are unable to short it (or essentially hedge your long position), how will you be able to hedge price risk at all? To sum up, not only will people be limited in their ability to hedge, the average consumer will likely not take the time to manage their risk with futures given the learning curve and capital needed to do so.
Cost of Substitution
In the energy business multiple commodities can be substituted to produce electricity. For example, coal and natural gas are well-known to compete with each other at power plants when prices on an Btu basis are near parity. In 2008 when the financial crises occurred and gas prices saw a steep decline from oversupply, we saw natural gas prices reach a floor of roughly $2.30 to $2.50/MMbtu because that was the point at which it did not make sense for coal-fired power plants to run and we needed to burn gas to clear inventory. Gas was just too cheap and the two commodities competed for consumption at power generation facilities, setting up a knife fight for the lowest possible price which continues today.
When looking at cryptocurrencies, I see a very similar situation. All of them are essentially run off the same concept – blockchain. There are few notable differences though, and one is in transaction fees. Bitcoin charges the highest fee of all the major cryptocurrencies whereas some of them do not even levy a charge. One of them has even gone an extra step to implement “smart contracts” which is just an algorithm that executes transactions based on certain criteria being met, thereby reducing human error and adding a layer of trust.
Other than fees and smart contracts, there is really not much inherent difference among all the competing cryptocurrencies. This results in them looking more like substitutable commodities (for instance, a Smucker’s jam versus the house brand jam), rather than unique, individual products providing unique services.
What does this mean for the price of Bitcoin? If people continue to adopt competing cryptocurrencies, as they already have indicated in the chart below, Bitcoin’s value will have difficulty sustaining such a high price. The price may certainly continue to go higher in the near term as it gains more popularity and goes main stream, but ultimately the price will need to reflect the fundamentals (supply and demand) and so far the fundamentals pose a strong case for a downward price spiral or at least converge with that of its most competitive rival.
The world has evolved rapidly over the past decade and cryptocurrencies are no doubt becoming more main stream and changing the way we look at financial transactions.
Given the few differentiation factors that exist among them, public acceptance will be key in deciding who the winners are and exactly how much they might be worth. People have placed an absurd price on Bitcoin which is unjustified, in my opinion, but if you were one of the lucky ones who got in early, enjoy the ride because it is likely to be short and sweet.
With that, I will leave you with a thought from a famous financial analyst regarding market prices of assets, which fits perfectly with this Bitcoin frenzy:
“The market can remain irrational longer than I can remain solvent.”