Valuing Bitcoin: what are the challenges & solutions?
After more than a decade in existence, Bitcoin — the original cryptocurrency and largest one by market share — has finally found significant institutional acceptance.
Unless we live in or travel to a country like El Salvador, where Bitcoin is legal tender, we generally can’t transact on a day-to-day basis with BTC just yet albeit Paypal is allowing consumers in the US and Europe to transact with BTC. However, many financial institutions and prominent businesses have given their stamps of approval, so it seems like Bitcoin is on its way to becoming more accepted as a legitimate currency, in addition to being seen as a store of value like a digital form of gold by institutional investors.
That said, our financial ecosystem is still very much in the midst of adapting to Bitcoin. One of the challenges is around valuing Bitcoin. What kind of framework should we collectively use to put a value to Bitcoin?
What gives Bitcoin value?
In general, economists agree that for a currency to be successful, it must meet several criteria:
Scarcity: Whereas central banks can increase supply indefinitely by printing fiat money, and the total supply of gold is unknown and possibly unlimited, we do know that the total Bitcoin supply has a hard cap of 21 million. So, Bitcoin outranks established currencies like fiat money and gold in this area.
Durability: Banknotes can be destroyed or mutilated, but Bitcoin’s digital nature makes it impossible to destroy. Furthermore, all Bitcoin records are permanent and irreversible on the blockchain ledger. Being both ultra-durable and -scarce allows Bitcoin to retain value over time i.e. resist depreciation.
Counterfeitability: With its decentralized blockchain and robust Proof of Work validation method, Bitcoin is almost impossible to counterfeit. In contrast, banknotes are easier to fake and gold easier to adulterate.
Divisibility: The more divisible a currency is, the more usable it becomes. For example, we don’t use gold in everyday transactions because it’s difficult to divide into the exact amount you need. Both fiat money and Bitcoin are much more divisible. The smallest unit of Bitcoin is 0.00000001 BTC which is worth about one-hundredth of 4 cents.
Transportability: Similarly, the more portable a currency, the more likely people will use it. This is another reason gold was replaced by fiat money. Cryptocurrencies are arguably even more portable than fiat. It takes only minutes or even seconds to transfer Bitcoin between parties on a crypto exchange or between e-wallets, including across geographical territories.
Utility: All of the above criteria contribute to a currency’s utility, which describes how practical and common it is to use as a means of exchange. Although Bitcoin’s decentralized blockchain promises immense utility, we have a long way to go before Bitcoin can replace fiat currency.
This is partly because of Bitcoin’s historic price volatility, making it less than ideal as a currency. It’s hard to get people to accept a currency whose market price may plummet the next day. However, Bitcoin supporters agree that any price fluctuations should even out over time along with mainstream adoption.
Security issues like theft and hacking on unregulated crypto exchanges and wallets also discourage users from transacting with Bitcoin. This would take time to work out as the crypto ecosystem matures. In the meantime, investors can get around this issue with institutional-grade Bitcoin funds which adhere to strict financial regulations.
Bitcoin as currency: Quantity Theory of Money
Although Bitcoin checks most of the boxes as a currency, there is as yet no consensus on how to determine its true value. This is all the more difficult since Bitcoin’s price has largely been driven by speculation. How do we tell if it is over- or under-valued?
One compelling method, favoured by accounting firm EY, is to apply the classical Quantity Theory of Money to Bitcoin. This method is represented in a simple equation:
M*V = P*T
M = money supply (in this case, the supply of Bitcoin tokens in circulation)
V = velocity (how quickly Bitcoin changes hands in a given period)
P = price of Bitcoin (what we’re trying to find)
T = transaction volume (value of goods and services transacted with Bitcoin in a given period)
Once we know the values of M, V, and T, we can derive P, the price of Bitcoin.
M is the easiest to plug in, since we know there are 18.6 million mined Bitcoins. But V and T are much harder to estimate.
V refers to the frequency of money changing hands, but, for the purposes of this formula, only actual spending on goods and services should be counted. Buying and selling Bitcoin for speculative purposes should not count.
Meanwhile, T is the total value of goods and services bought with Bitcoin, expressed in fiat currency (e.g. US$500 billion). It’s difficult to estimate this right now, since businesses are still in the early stages of accepting Bitcoin as payment.
Bitcoin as store of value: total addressable market
One common school of thought around Bitcoin is that it is a store of value rather than currency.
According to this view, we are more likely to hoard it (like gold) than spend it (like fiat money). Thus, a model like Quantity Theory of Money — which relies on a model of money changing hands frequently for goods and services — would not work.
Those who subscribe to the “store of value” philosophy, such as financial firm 21Shares, benchmark Bitcoin against the gold market.
In this method, we divide the market capitalization of gold (US$10 trillion) by the total number of Bitcoins in circulation (18.6 million) to determine the price of one Bitcoin. The result is about US$535,000, which represents Bitcoin’s price at “maturity”.
However, this entire valuation framework hinges upon the fundamental assumption that the gold market is a sound indicator of Bitcoin’s “total addressable market”.
Some find it hard to imagine that Bitcoin’s market share will ever reach the same size as that of gold, while others conversely believe the Bitcoin market will exceed that of gold. Only time will tell which assumption is correct.
Another issue is that Bitcoin still needs to be evaluated as money before we can liken it to gold. If we fail to establish its intrinsic monetary value, then, as the EY white paper points out, there is little to distinguish Bitcoin from collectibles like art or fine wines.
Valuing Bitcoin: a work in progress
Apart from the valuation frameworks described above, there are numerous other methods used to determine the price of Bitcoin.
These range from thinking in terms of technological adoption (estimating how much of total economic activity will eventually shift over to Bitcoin) to cost-based approaches (estimating the total costs of mining a Bitcoin).
As yet, there is no widespread agreement on how we should price Bitcoin. But the fact that so many people — economists and armchair thinkers alike — debate the issues indicates that valuing Bitcoin is a worthy pursuit.
These discussions and theories are invaluable for the professional cryptocurrency investor, especially those looking to invest in the long term.
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