Valuing A BitCoin

This is not a post about what BitCoin is worth today, or will be worth in the future. No part of this should be construed as a recommendation to buy, sell, or hold BitCoins. If you landed here because you are wondering whether you should buy, sell or hold BitCoins, you need to do research elsewhere or consult with a trusted financial advisor, who can render an opinion based on your unique financial circumstances.

What this post is about are three different mental models one might use or adapt in analyzing the current price of BitCoin or another digital asset with similar characteristics.

First some background. I am fortunate to be friends with some very smart people with diverse sets of interests. We enjoy nerding out over similar topics: business strategy, financial analysis, technology, markets, entrepreneurship. If we can nerd out in person over a bottle of whiskey, all the better. Unfortunately now many years out of college several of us live in different cities. So we created a Slack group where we more or less maintain a running dialogue. Several of the longest running threads in our Slack group deal with cryptocurrencies.

I am not going to spend time or energy on background information in this post. There are smarter and more knowledgeable people than me all over the internet who can bring you up to speed on cyrptocurrencies. However, you should read the original BitCoin whitepaper. Primary sources matter. It doesn’t matter if you don’t understand every last detail. I certainly don’t.

The specific problem we were confronting on Slack was which type of mental model one might apply to a cryptocurrency like BitCoin to determine whether it is overpriced or underpriced at current market rates.

For example, there is an old saw about bank stocks that goes something like this: buy them at 1x book value and sell them at 2x book value. Whether 1x or 2x is the right multiple is irrelevant for the purposes of this discussion. The point is that the mental model for a bank or finance company revolves around the book value of its equity.

So what mental models might apply to cryptocurrency? We debated three on Slack:

1.       Purchasing Power Parity (PPP)

2.       Relative Value vs. Gold

3.       Supply/Demand Balance

Purchasing Power Parity

Purchasing power parity is the classic approach to assessing whether one currency is overvalued or undervalued relative to another (the key underlying assumption here is that BitCoin should be treated as a currency). PPP asserts that similar baskets of goods and services should trade for similar prices around the world. The Economist half-jokingly created The Big Mac Index in 1986 to analyze currency valuations around the world. Today The Economist has a dedicated web page devoted to Big Mac Index data, and the data has formed the basis for many books and academic studies. Here is what the Big Mac Index looks like today:

Source: The Economist

Pros: Intuitive, straightforward, much of the data is readily available. Captures the fact that BitCoin inflation should remain subdued versus fiat currencies over time (the supply of BitCoins is fixed at around 21 million whereas there is no limit on the amount of cash a government can print).

Cons: Goods and services are not priced “natively” in BitCoin. Starbucks does not say “a Grande Mocha costs $4 or 1 BTC” (indeed if that were the case BTC at $3,500 would seem wildly overvalued). This essentially blows up the PPP approach. Although personally I believe that if cryptocurrency truly goes mainstream, we will eventually get to the point where goods and services are priced natively in BTC and the PPP approach may have more analytical utility.

Relative Value vs. Gold

This was a simple thought experiment I conducted. Would I rather have an ounce of gold or 1 BitCoin? At the time I asked this question an ounce of gold was trading for about $1,300 and 1 BTC was trading for around $3,500. The intuition here is that gold and BitCoins essentially function as stores of value, where the market simply “agrees” on the value to assign each unit.

Pros: Exceptionally straightforward. Captures the notion that both gold and BitCoins have value more or less “because we agreed they have value” (if someone can explain to me why gold is considered to be a store of value, please drop me a line in the comments. Sorry gold bugs — I must confess I have never really understood why gold is so revered as a store of value).

Cons: Differences in unit measures. My comparison above makes 1 BTC look overvalued versus one ounce gold. But if you looked at the total value of the respective markets, BTC is worth an aggregate $50 billion while gold is worth an aggregate $9 trillion or so. On that basis, gold looks wildly expensive versus BTC.

We went around in circles on this for a long time. Personally, I still feel it is a useful thought experiment, though it raises hackles with others.

Supply/Demand Balance

A commodity like oil trades where supply and demand balance. On the demand side, human civilization requires a certain number of barrels of oil per day to function. This is something that can be estimated. On the supply side, it costs an exploration and production company a certain amount of money to get the oil out of the ground. So if it costs $50 to get a barrel worth of oil out of the ground, over the long term that sets a kind of floor for oil prices. Below that level, companies will not be able to cover their costs, more and more will go bankrupt and eventually the price will correct back toward an equilibrium level. This is of course a massive simplification but it illustrates the key principles.

Likewise, the BitCoin infrastructure is underpinned by the “miners” of the coins. Miners deploy the computing power that powers the network. They are incentivized to do this through the award of BTC for verifying transactions. The interesting wrinkle is that the system adjusts dynamically so that as more computing power is deployed on the network, it becomes more difficult to mine BTC (the awards get relatively smaller). At the same time, the miners’ costs rise, primarily due to ever-increasing electricity consumption. The reverse happens as computing power leaves the network (say, if unprofitable mining operations shut down). Several years ago you could mine BitCoin economically on a commercial laptop. Now profitable BitCoin mining requires significant scale and capital investment.

BitCoin’s supply side economics are relatively straightforward to understand at a high level. The demand side is more challenging. For me the most significant impediment to modeling the demand side is that the majority of BitCoin transaction activity currently appears to be speculative trading. If the data in the linked article is to be believed, less than 1% of transactions are related to actual payment processing, with exponentially higher volumes driven by trading activity. This creates some reflexivity as relates to “network fundamentals.” More trading activity -> more transactions -> implies higher demand. However, that self-reinforcing momentum can easily unwind again on the way back down. I do not have an easy answer for how to deal with this, but I have the sense that it is of critical importance.

Conclusions (Such That They Are)

If you are a BitCoin trading enthusiast, and you are still reading this, I imagine that you are thinking something along the lines of “this idiot spent 1,000 words on that!? I am no closer to understanding whether now is a good time to buy!”

To reiterate: this is not a post about what BitCoin is worth today, or will be worth in the future. No part of this should be construed as a recommendation to buy, sell, or hold BitCoins. If you landed here because you are wondering whether you should buy, sell or hold BitCoins, you need to do research elsewhere and consult with a trusted financial advisor, who can render an opinion based on your unique financial circumstances.

All useful analysis is rooted in finding the right questions to ask. Looking at a simple bank stock, for example, the right questions are along these lines: what is a fair estimate of book value per share? Is the quality of the loan book truly reflected on the balance sheet? If not, how do I adjust those numbers to more accurately reflect reality? Usually these questions will lead you to further questions centered on the breakdown of the bank’s loan book and the quality of its underwriting standards.

Similarly, the first step toward assessing whether BitCoin is overpriced or underpriced involves identifying the right questions to ask about its fundamentals.

What do you think?

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