Valuing Bitcoin - Pt. 1
The ability to value an asset is essential to making well-informed decisions about your investments. With stocks and bonds, we have well-understood frameworks like the Dividend Discount Model, Discounted Cash Flow Model, or Comparables Methods. How do you value the currency of a decentralized, global financial network? I often hear something like, “bitcoin doesn’t have fundamentals so you can’t value it,” and “bitcoin can’t be valued, so no one can properly invest in it.”
A verifiably scarce, globally accessible digital money sounds like it might be something worth investing in. But with a lack of cash flow, a balance sheet, or dividends, investors can’t apply their flavor of a valuation model. Instead, we have to make a relative comparison to something like gold or use a modified method. There are a lot of valuation methods and frameworks. In no particular order, we will look into the following;
1. Stock-to-flow - Pt. 1
2. Store of value/Gold - Pt. 1
3. Metcalf’s law - Pt. 2
4. National currency methods - Pt. 2
5. Quantity Theory of Money - Pt. 3
6. All-in-sustained-cost - Pt. 3
7. honorable mentions - Pt. 3
Stock-to-flow
The stock-to-flow model comes from precious metal markets, with two variables; the stock (total supply) and flow (annual issuance or production). The stock is divided by the flow to form a ratio. The higher this number, the harder it is to produce; thus, that metal is more scarce. The stock-to-flow ratio of gold is 60, silver is 22, and platinum is 0.4. The bitcoin stock-to-flow ratio is 58.
This sock-to-flow ratio was used by an individual going by the name PlanB to formulate a model predicting the price of bitcoin given the stock-to-flow. Essentially, the model assumes that scarcity drives value similarly to gold.
The stock-to-flow (S2F) model shows the current price mapped on an assumed “super cycle” following a boom and bust in price driven by scarcity. Keep in mind that the S2F model has many variations with different targets.
The problem with this model is that it assumes we continue following a highly predictable boom and bust cycle. It also has a huge range, two standard deviations. For example 2024 has a range from $30,000 to $400,000. The model also predicts a $1,000,000 bitcoin in 2025. Although I believe that value is achievable, it won’t happen in 2025.
The utilization of the stock-to-flow ratio is good. On the other hand, I wouldn’t place much value on this model. In the original post discussing the model, the creator talks about where this new capital will come from, and he says,
People ask me where all the money needed for $1trn bitcoin market value would come from? My answer: silver, gold, countries with negative interest rate (Europe, Japan, US soon), countries with predatory governments (Venezuela, China, Iran, Turkey etc), billionaires and millionaires hedging against quantitative easing (QE), and institutional investors discovering the best performing asset of last 10 yrs.
I 100% agree with that prediction. Since PlanB wrote that, we did see bitcoin reach a $1 trillion market cap, and it was during a period of new institutional buyers, record QE, negative interest rates in Europe, and worsening authoritarianism in the countries mentioned.
Gold
This is less of a valuation method and more of a combination of characteristics that result in something everyone agrees is valuable and subsequently a store of value. We have a baseline for comparing gold and bitcoin from this value and other known factors.
These characteristics include;
- durability
- acceptability
- divisibility
- uniformity and fungible
- industrial and technological applications
It’s essential to realize the relationship between the value and its designation as a store of value. Those two ultimately become unified and self-fulfilling. Not only is store of value a core function of money, but the designation creates a market based on those characteristics, and that market constantly reinforces the value.
The reason people own gold is at least one or a combination of the following;
- proven history
- weakening dollar
- inflation hedge
- geopolitical uncertainty
- finite supply
- increasing demand
Gold is a finite resource that is difficult to find and has a reasonably stable value regardless of the current economic situation. Add this with the fact that gold is incredibly difficult to destroy, and every culture applies significance to gold beyond its properties of money, and it’s no wonder why 2-3% of global wealth is in gold [1].
Bitcoin shares all of the characteristics of gold that lead to gold being a globally accepted store of value.
Durability - You can not destroy bitcoin. Bitcoin is never inaccessible
Acceptability - 30,000 merchants, easy access to store credit,
Divisibility - 1 (one) Bitcoin can be subdivided into 100,000,000 pieces
Uniformity - 1 Bitcoin = 1 Bitcoin. There is no “coin premium”
Technological applications - If you use a digital payment layer today, bitcoin could replace it and provide more value.
Let’s assume you only agree 25%. In other words, you agree that bitcoin shares 25% of the value of gold due to the same characteristics that gold derives its value. That would mean you believe the bitcoin market capitalization should be 25% of gold.
An estimated 205,000 tonnes of gold are in circulation (mined and above ground) at $1,800 an ounce, which gives us a total market capitalization of $11.8 Trillion.
There is precisely 19,124,193 bitcoin in circulation (as of writing). $24,000 per bitcoin gives us a market capitalization of $458 Billion.
If bitcoin becomes treated the same way gold is, and the result is a conversion of bitcoin from gold at 25% of the current market, the market capitalization would be approximately $3 Trillion. Assuming no supply change, that would value 1 bitcoin at $155,000.
What if you believe that bitcoin is equivalent to gold (1-to-1) based on the characteristics, and you accept the reasons for ownership are sufficient? You would be assuming a value of $621,211 per bitcoin (at current supply).
If you believe bitcoin is TWICE as valuable as gold due to either technological interoperability, greater accessibility, more portable, or more secure, then would you be assuming a value of $1,242,423 per bitcoin (at current supply).
Comparing bitcoin to gold, in this way, allows for a straightforward valuation using the most widely understood asset in human history. As comforting as these numbers might be, a lot is being left out. What are the second-order and third-order effects if trillions of dollars in gold are liquidated, and then trillions of dollars are now trying to buy bitcoin? How does this affect the ancillary markets of each? These are no longer independent markets; what sort of correlation do we now have? Central banks hold 1/5 of all the gold ever mined; how do they react?
As much as I love this comparison method because it’s simple, easy to understand, and easy to communicate, it seems too convenient for this to be the end-all-be-all. The characteristics of gold transfer well to bitcoin, and thus the value should also follow. The question then becomes, when? History will be the biggest obstacle to converting from one primary store of value to another. Bitcoin is competing against something humans have been interacting with since 40,000 BC. This history affects culture, and culture affects capital. Why trust something new with 13 years of history when you could trust something old with 42,000 years of history? There is more risk when going with something new, but the reward is significantly higher. In a world of Moore's law and advancements in technology faster than anything ever seen before, I would expect that 42,000 years difference to be made up rather quickly.
End Part 1
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Sources:
2-3% of global wealth is in gold: https://companiesmarketcap.com/gold/marketcap/
https://www.credit-suisse.com/about-us/en/reports-research/global-wealth-report.html