How to Value Bitcoin and Other Cryptocurrencies
Cryptocurrencies are one of today’s hottest asset classes to invest in. Bitcoin in particular has soared in price from pennies to thousands of dollars per unit within a decade.
But is it all a bubble, like the Dotcom era or tulip mania? Or is this just the start of something bigger, or even revolutionary?
Price is what an investor pays, but value is what an investor gets. It’s easy to look up the current price of Bitcoin, but it’s harder to determine what a realistic value is.
This article provides a few frameworks to help you think about how to determine Bitcoin’s value for yourself, and the value of other cryptocurrencies, including explaining a lot of the risks involved
November 2020 Editor’s Note:
I originally wrote this article in autumn 2017 when Bitcoin was in the range of $6,000-$7,000, and had a neutral outlook, leaning a bit bearish (with no personal position). I updated the article every few months with new numbers to keep it fresh.
For the next 2.5 years after publication, Bitcoin went up to $20,000 and collapsed to under $4,000, went up to $12,000 and briefly collapsed again to under $4,000, and by April 2020 was back up to $6,000-$7,000. So, it had 2.5 years of sideways, choppy performance after the original publication.
In my premium research service in April 2020, as it came out of that sharp dip, I became bullish and initiated a long position in Bitcoin. I then wrote two public articles about Bitcoin during 2020, explaining why I am bullish:
3 Reasons to Invest in Bitcoin (July 2020)
7 Misconceptions About Bitcoin (November 2020)
Those two articles share my more up-to-date thoughts on Bitcoin than this article.
I update this article less frequently than before, but I keep it for legacy purposes, as it still provides a contextual backbone for thinking about digital monetary assets.
Cryptocurrencies 101: A Blockchain Overview
Bitcoin, the first cryptocurrency, was invented by an anonymous person or group named Satoshi Nakamoto and released publicly online in 2009 as open-source software and a white paper that explains the concept.
Satoshi claimed to be a Japanese man in his thirties, but his identity has never been verified because all of his communication was via the Internet. He wrote with influences of British English, and had sleep/wake cycles according to his online activity that would presumably place him in North America, leading many to believe that he’s not actually Japanese. Or maybe he’s multi-ethnic.
It might not even be a man. It could conceivably be a woman or a group of people. But most likely it’s a man using a pseudonym. And wherever he is, he has about a million bitcoins, worth billions of dollars now, which he has never spent. And he has gone dark; after having invented the concept, he no longer leads it and his whereabouts and identity are unknown.
It’s like a good thriller novel.
Anyway, Bitcoin was invented for the purpose of being a decentralized currency and method of payment. It does not rely on any central authority like a government or bank or Satoshi himself, and is instead completely distributed on numerous clients running open-source Bitcoin software.
At the core of most cryptocurrencies is blockchain technology, which now has applications outside of just cryptocurrencies.
As the Harvard Business Review described:
Contracts, transactions, and the records of them are among the defining structures in our economic, legal, and political systems. They protect assets and set organizational boundaries. They establish and verify identities and chronicle events. They govern interactions among nations, organizations, communities, and individuals. They guide managerial and social action.
The technology at the heart of bitcoin and other virtual currencies, blockchain is an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way.
With blockchain, we can imagine a world in which contracts are embedded in digital code and stored in transparent, shared databases, where they are protected from deletion, tampering, and revision. In this world every agreement, every process, every task, and every payment would have a digital record and signature that could be identified, validated, stored, and shared. Intermediaries like lawyers, brokers, and bankers might no longer be necessary. Individuals, organizations, machines, and algorithms would freely transact and interact with one another with little friction. This is the immense potential of blockchain.
In other words, blockchain is a new foundational technology that uses decentralized encryption to record events publicly. The technology was conceptualized in the 1990’s, but not implemented until Satoshi applied the idea to his Bitcoin software and solved the double-spending problem, creating a scarce digital currency that relies not on governments or banks, but on encryption.
With Bitcoin, each user has a private key, which is a giant integer number that acts like a digital signature, and is kept secret, known only to that user. Users then have public addresses (more numbers), that people can send money to for the purpose of a transaction.
You don’t actually “store” bitcoins anywhere. It’s just a public ledger that attributes a certain number of bitcoins to addresses that you control with your private key. The thing you store, is just your private key.
Bitcoins can be “mined” by verifying the transactions of third parties. People can contribute computing power to verifying Bitcoin transactions, and in exchange, the algorithm allows them to create a certain amount of bitcoins for themselves. The total number of bitcoins will max out at 21 million, at which point they can no longer be mined.
Since Bitcoin technology is open-source and not proprietary, other cryptocurrencies can be and have been created, and many of them like Litecoin even have specific advantages over Bitcoin itself, like faster processing times.
Another big blockchain application is for software. Ethereum, now the second largest cryptocurrency, was developed to be broader than Bitcoin in terms of using blockchain technology to transfer various types of value. It is like a decentralized app platform with a built in currency in units of ether. Typical app platforms have a central authority like Google or Apple, and developers can request to put apps on those networks to sell to consumers. Ethereum can do that without the middle man.
Bitcoin vs. Fiat Currencies vs. Precious Metals
You might naturally be asking yourself what the potential advantages of cryptocurrencies are. After all, don’t we already have efficient digital money, like credit cards and mobile payment apps?
Historically, there are two types of money. Precious metals and fiat currencies. Cryptocurrencies are a new, third type.
Precious Metals
For thousands of years across several continents, humans have traded valuable commodities as forms of value, to make bartering easier. Any material that has scarcity and desirability and that can be divided into small amounts works well enough, but gold and silver are the near-universal choices.
Gold in particular is rare and pretty, extremely resistant to reaction (i.e. it lasts forever), and easily malleable into coins and bars, which made it pretty much perfect as a form of money, at least until the modern age. It’s no longer practical or even possible to walk around paying gold and silver for things you want to buy, unless government currencies go back to using a direct gold standard. It also has plenty of industrial use due to its chemical properties, but its price level keeps most of its use for money and jewelry.
The main advantage that gold still has is that no government has price control over it. It has inherent value and scarcity all on its own, and is recognized everywhere. Investors view it as catastrophe-insurance, because it will always have at least some form of value and offers protection against inflation, fraud, and economic collapse.
Fiat Currency
Dollars, pounds, yen, and all other currencies are “fiat currencies”, which means they have no intrinsic value other than that a government has decreed that they are legal tender and require them for the payment of taxes. They can print as much as they want.
Fiat is Latin for “let it be done”. United States dollars have value because the United States government declares that they have value and makes it the only legal tender to pay U.S. taxes with, and people have enough faith in the stability of that declaration to go along with it and use it as a medium of exchange and store of value, even though over time, the dollar has lost most of its purchasing power through inflation of the money supply.
Fiat currencies are convenient, but not without risks. When a government fails, its fiat currency typically hyper-inflates into being worthless. Most fiat currencies ever created have eventually become worthless; the ones that exist now are all fairly recent and have lost most of their purchasing power over time.
Cryptocurrencies
Bitcoin was invented to be like a new, modern form of gold and silver. Like some libertarian sci-fi form of money.
It is scarce, durable, portable, divisible, verifiable, storable, relatively fungible, salable, and recognized across borders, and therefore has the properties of money.
It’s digital, and can be used for both in-person transactions and online transactions, assuming both the buyer and seller have the technology and willingness to use it.
It’s decentralized, meaning its existence and value is not tied to any agency, government, corporation, or bank. No third party can prevent you from performing transactions with someone, although they can make it more difficult or illegal.
It’s able to be broken into tiny fractions. You can send someone 0.08235179 bitcoins, for example.
It’s secure, as long as you protect your private key. Bitcoin uses a level of standardized encryption for which even the top supercomputers would take far longer than the current age of the universe to break. The core algorithm is quantum hard, meaning that even theoretical quantum computers of the future won’t be able to break the blockchain itself and alter it. However, the ability to find specific private keys may one day be possible by quantum computers, but there are potential solutions to defend against that, and Bitcoin’s protocol can be updated by consensus if need be.
It can’t be tracked or regulated easily. Although all transactions are on the public ledger, there are steps to distance the user from the transaction, making Bitcoin transactions difficult to trace. However, increasingly sophisticated methods, combined with “Know Your Customer” policies on major fiat-to-crypto entry points like exchanges, have made it far easier to track over time.
You don’t have to trust organizations with your private details. To buy with a credit card, you have to give your credit card info, and occasionally those databases get hacked. But to buy with bitcoins, you never have to give anyone your private key.
For these reasons, Bitcoin and other cryptocurrencies share some characteristics with precious metals. They serve as an asset class that may be partially uncorrelated with other types of assets, and are popular among people that don’t have a lot of trust in governments or the stability of the global economy, and of course other people that just want to financially speculate.
Unfortunately, this also makes cryptocurrencies perfectly suited for criminal activity. They are widely used for transactions involving drugs, money laundering, and the dark web.
The Difficulty in Valuing Cryptocurrency
Most buyers and sellers of cryptocurrencies are speculating, meaning they are just looking at price charts and guessing that it may go up or down with technical analysis.
Fundamental investing, on the other hand, uses a bottom-up approach to find the inherent value of something. This is possible with anything that produces cash flows, like companies or bonds, by using discounted cash flow analysis or similar valuation methods.
But when something doesn’t produce cash flows, like commodities, it gets trickier.
In my article on precious metals, I described how there are numerous ways to determine an approximate value for gold and silver, even though they don’t produce cash.
You can, for example, consider how much money it takes to mine those metals out of the ground per ounce, which has significant effects on the supply/demand balance of them.
You can also compare the long-term (multi-decade) inflation-adjusted price of gold and silver, to see how they have changed in purchasing power over time.
Lastly, you can compare them to other commodities, like the gold-to-oil ratio.
There’s no one answer for exactly how much a precious metal or other material is worth, but what those methods can give you is a reasonable range for where the price should be, and helps you identify the specific assumptions you need to make for certain valuation estimates to be correct.
And what makes all of these valuation methods remotely possible is that gold and silver have inherent scarcity; there’s only so much that can be economically mined. In fact, the total volume of all gold ever mined can be fit into a cube of less than 25 meters on each side.
Likewise, any individual cryptocurrency is scarce. For example:
Bitcoin’s algorithm limits it to 21 million bitcoins total.
Bitcoin Cash’s algorithm limits it to 21 million bitcoins total
Litecoin’s algorithm limits it to 84 million litecoins total.
Ripple’s algorithm limits it to 100 million ripples total.
Ethereum’s algorithm is flexible, which is a common criticism.
The problem is that although the units of any individual cryptocurrency are scarce, unlike precious metals there is no scarcity at all when it comes to the total number of all cryptocurrencies that can exist. Any programmer can make his or her own cryptocurrency, with the hard part being that it’s worthless until enough people recognize it, adopt it, and begin to trade it around.
Here’s a list of all current cryptocurrencies. There are thousands of them!
Aside from stablecoins that are linked to fiat currency, there are 3 cryptocurrencies that have over a $10 billion market capitalization. Bitcoin, Ethereum, and Ripple are the three that are far in the lead in terms of adoption. Bitcoin in particular has two-thirds market share of the entire cryptocurrency market capitalization, with all other thousands of cryptos together equaling the other one-third.
When I originally wrote this article in 2017, Bitcoin was worth $6,500 or so. It then went on to increased to over $19,000 only to come back down to under $4,000, and since then it has popped back up to over $10,000 and then down to well below $10,000 again. I keep this article updated from time to time, but less often then before.
Cryptocurrencies will only be worth serious money over the long term if they take off as a method of spending or store of value and a handful of cryptocurrencies continue to make up most of the market share, rather than all cryptocurrencies becoming extremely diluted. So far that is happening; Bitcoin is maintaining market share among the growing number of coins.
One of the ongoing debates has been what the ideal block size should be. Small block sizes greatly slow down the network and make a currency unscalable, while big block sizes require bigger data centers to process, meaning the currency’s network can become highly centralized, which is exactly what users don’t want to happen. Some solutions process transactions off the blockchain and then reconcile them with the blockchain, like batching multiple transactions into one big transaction. However, with Bitcoin’s increasing usage as a store of value rather than a medium of exchange, transaction time has become less important.
All that debate around block sizes and off-chain scaling solutions, plus all the other features of certain currencies, makes it challenging to predict which currencies will end up with dominant market share. Which ones will solve all the primary problems in the best way, and achieve the widest adoption?
These currencies are volatile, their market share is fickle, and updates can result in split currencies, which has happened to both Ethereum and Bitcoin. However, historically when this happens to these major networks, the original network maintains the vast majority of the market share.
Moreover, the underlying functions used by these schemes may be:tether 2 bitcoin список