Categories
Valuation

Bitcoin Pricing – Upside with Increased Adoption

Summary:

  • We dive into different methods of valuating the “intrinsic” value of Bitcoin and get a range of results
  • We focus on 3 main valuation methods and outline them: TAM valuation, Metcalfe Valuation, and the Monetary Equation. We also talk about the “cost of production” method and the stock-to-flow model, but their assumptions both fall short in our view.
  • Each has its own built in assumptions and philosophy in its approach to valuing Bitcoin. Each also implies different levels and ranges of extreme upside given more widespread adoption and acceptance.

There has been much debate on the intrinsic value of Bitcoin. Bulls insist that Bitcoin and cryptocurrencies at large are in their nascency and the future holds a world where crypto is commonly used as a medium of exchange and we use a cryptoasset-powered blockchain to conduct business and activities such as international payments, healthcare, information settlement, and much more. Bitcoin bears insist there is a lack of historical evidence of real use cases, Bitcoin is too volatile to be a real store of value or medium of exchange, scarcity is irrelevant and not an indication of value, and that the future bulls paint is merely a pipe dream.

We concede each side has some correct points, but this write-up isn’t to debate the merits of Bitcoin, but rather to attempt to price it. NYU Professor Aswath Damodaran said back in 2017 on Bitcoin, “Not everything can be valued, but almost everything can be priced.” We agree professor! He further points out, “cash generating assets can be both valued and priced, commodities can be priced much more easily than valued, and currencies and collectibles can only be priced.” We believe Bitcoin is somewhere between commodities and currencies/collectibles. We take a look at future return drivers by asset classes including cryptoassets in the table below. With all that said, let’s dive in!

Approach 1: Total Addressable Market

The most popular and commonly used approach to pricing cryptocurrencies is to estimate their total addressable markets ((TAM)) and compare that estimate with crypto’s current market capitalization. For example, most finance media and commentators believe that gold is the most obvious comparison as a non-sovereign store of value. Taking the gold price of around $1860 as of writing and the USGS website’s estimate of 244,000 metric tons of gold being discovered to date (187,000 metric tons historically produced plus current underground reserves of 57,000 metric tons), we get a Gold TAM of approximately $16 trn. For analysis purposes, we use the 21 million controlled supply of Bitcoin for a full dilutive number to use to estimate value per Bitcoin.

Sources: goldprice.com, USGS.gov, our estimates,

Bitcoin has achieved slightly less than 5% of the total value of gold according to current Bitcoin prices as of writing. We take this exercise further and include other store of value assets such as negative yielding debt, art, and offshore assets. There is approximately $18 trn of negative yielding sovereign debt currently, over $64 bn worth of art, and an estimated $32trn in offshore assets back in 2012 according to Reuters.

Source: Bloomberg estimates, Statista.com, Reuters, Tax Justice Network, our estimates

If we add up all these store of value assets with gold’s TAM, Bitcoin’s market cap has achieved only 1.2% of their total value. Finally, there is one more store of value asset that dwarfs all the others – real estate. The value of all the real estate in the world is estimated to be $280 trn according to Savill’s. Adding up all these store of value estimates, we get close to $350 trn in total value. Meaning Bitcoin has a current total market cap only 0.2% of all store of value assets’ total value.

Based on the total addressable market pricing method, Bitcoin clearly has multiples of room to run.

The Equation of Exchange Method

An alternative pricing model was proposed by Chris Burniske, a crypto researcher, and Jack Tatar, managing partner of Doyle Capital, in a book called Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond.

In it, the authors introduce a framework widely referred to by the monetary equation of exchange MV = PQ. This model is used traditionally for valuing currencies and is based on the assumption that a currency’s value is related to the size of the market it supports and the rate at which the currency is exchanged in an economy. The definitions of each input are in the table below.

Source: CFA Institute

We get the velocity, number of transactions, and average price of transaction per year of Bitcoin from charts.bitcoin.com. We take the final day velocity, number of transactions annualized, and average price of transaction as of writing.

An example of a transaction value chart courtesy of charts.bitcoin.com

As Bitcoin becomes more widely adopted, all of these metrics should continue to increase, thus leading to an increase in value of Bitcoin according to the model. Using all of our most recent data on Bitcoin, we get a value of around $45k per Bitcoin.

Source: our estimates

We take a look at a range of scenarios with these variables and examine their effects. The first table is the QP side of the equation and the second below table is a range of Bitcoin values based on those above quantities and average price of bitcoin transaction, then divided by the Velocity to isolate the M variable of the equation.

As you can see there is a wide range of price estimates using this approach in our different scenarios ranging from $6.5k to over $160k. What is also interesting is that the value of Bitcoin according to this method and using the most recent data for inputs gets pretty close to the current price of Bitcoin before the recent crash.

Cryptoassets as a Network

Another approach to pricing crypto is borrowed from Metcalfe’s law, a popular theory in technology that states “a network’s value is proportional to the square of the number of nodes in the network”. It is used to explain how the value of networks such as Apple, Facebook, Uber, Instagram, Twitter, and others have grown in value exponentially. When a network has a single user, it’s value is 0, however once you add a second, a third, a fourth user, the network’s value grows rapidly. The key part of Metcalfe’s law is that the value of the network is not linear, but rather a square function of the userbase. For example, a network of two users has a value of “4”, while a network of four users has a value of “16”.

Ken Alabi first proposed applying Metcalfe’s law to the valuation of cryptoassets in 2017 in his paper, “Digital Blockchain Networks Appear to be Following Metcalfe’s Law”. In the paper, Alibi showed that the valuation differences between certain cryptoassets (he uses Bitcoin, Ethereum, and Dash) can be explained with a high degree of accuracy.

We revisit Metcalfe’s Law in early 2021 and attempt to value Bitcoin by the same set of principles. We get the number of active Bitcoin addresses from glassnode studio and use the latest number as of writing of just over 1 million active addresses. Just for sanity, we use a second source bitinfocharts and get a similar number of active addresses. Through this method, we get a value of just over $50k for Bitcoin.

We take a look at a different range of number of active addresses to get a range of values of Bitcoin using this method. As you can see, each increase in the number of addresses increases the value of Bitcoin exponentially.

Source: Our estimates

Other Pricing Methods

There are additional pricing methods with less widespread acceptance, one of which is the “cost of production” valuation thesis. First proposed by Adam Hayes in 2015, the “cost of production” method holds that crypto, like any other commodity, is subject to traditional pricing challenges on the supply side. Hayes suggests that, with the view of Bitcoin as a commodity, each marginal Bitcoin’s cost of production should align with the price of the Bitcoin. For example, if Bitcoins had no real fiat monetary value, would crypto miners be incentivized to continue to spend real fiat money on the electricity costs as a part of mining new Bitcoin? It’s likely they would move to other, more rewarding ventures.

Ratio of bitcoin price observed in the market to the expected price produced by the model using historical data (source: http://www.blockchain.info). 1.00 would indicate that the two prices are identical, anything over 1.00 indicates a premium in the market and below a discount. The average for the study period is 1.05, σ = 0.33, indicating that over the long-term, the market price seems to fluctuate around the modeled price with striking consistency. Source: https://arxiv.org/ftp/arxiv/papers/1805/1805.07610.pdf

However, there are a few issues that come with this method. Its circular reasoning is a significant challenge as it uses two co-integrated variables to value one another. This logically has little explanatory power. Another issue is that the model fails to take into account the massive short-term volatility of Bitcoin or that Bitcoin’s mining difficulty is programmatically adjusted. The “cost of production” valuation method fails to clarify these cause-and-effect relationships and its predictive value is questionable.

Another final approach we want to touch upon is the stock-to-flow model. The model was first published in 2019 by a pseudonymous crypto quant researcher named PlanB. The stock-to-flow model states that Bitcoin’s price is indicative of its scarcity and that this scarcity can be measured by the stock-to-flow ratio – the relationship between the value of a Bitcoin and the new amount of Bitcoin being produced each year.

Source: https://www.lookintobitcoin.com/charts/stock-to-flow-model/

This approach is appealing because of its focus on scarcity as value. This approach also falls short because it conflates correlation with causation. Assuming that scarcity is the single factor driving Bitcoin’s price is a logical leap. In addition, the model ‘predicts’ a perpetually rising price for Bitcoin. For these reasons, the stock-to-flow falls short.

Conclusion

We believe each of these pricing methods have their own logical value as well as short comings and none are as sound or defensible as a traditional discounted cash flow analysis if for equities or credit models are for debt. Cryptoassets hold more similarities to commodities and currencies than to equity or debt, and the challenges to pricing commodities and currencies are well-known.

We would hesitate to use a single model with a few inputs to definitely price a cryptoasset. However, what is clear is that given increased adoption, usage, and acceptance, Bitcoin’s value should and will increase under any pricing model. Precision in pricing Bitcoin at this stage is impossible, but we are optimistic that more refined methods will come to exist in the future.

Our view is more aligned to that of the Bitcoin bulls. With crypto in a still early-stage of development and minimal professional investor allocation, we believe it has significant room to run. If small percentages of the trillions of dollars invested in adjacent store of value asset classes were allocated to Bitcoin, the impact and upside would be significant. As with anything there are risks, but with a long enough view, we believe the reward potential is enormous.

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