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There has been increased media, economist and investor coverage on Bitcoin recently, possibly due to the run up in pricing over the last week. So here I present a part 2 to my earlier article on what Bitcoin is (and isn't), and step off the solid foundation of reality into the free fall of speculation.

I've seen roughly three methods for valuation of bitcoins: 1) compare to gold (NYSEARCA:GLD), 2) compare to a company providing similar service such as Western Union (NYSE:WU) or Paypal (NASDAQ:EBAY), or 3) calculate values needed to support the transactional value.

You can get a good look at the comparison to gold from The Global Macro Investor here. The basic argument is that bitcoin is "digital gold". To me this smacks of valuing Amazon Web Services (NASDAQ:AMZN) by comparing it to the value of annual rainfall in Seattle because they both are made from 'clouds'. To be fair however, the analogy is that both have permanently limited supply and are increasingly difficult to dig up. Gold however has several very significant features that bitcoins are unlikely duplicate. First gold does have industrial use - it makes for a great sound conductor among other things. Second there is intrinsic consumer demand to acquire and hold the mental for non-economic reasons - lots of women like the shiny stuff no matter the price - which means there is persistent non-speculative demand. Third is that gold has a long history of being used as a store of value, even if it has been volatile recently. While gold speculation, and even gold as store of value, relies on one guy paying as much as or more than the previous guy for something he won't use, there is a long history of this so he is pretty likely to find the next guy. And let's not underestimate the scope of items 2 and 3 - India imported some 860 tons of the stuff in 2012 alone. Bitcoin may have been designed to have decreasing marginal supply ala gold and may use metal like terms, but no one is going to make bangles out of them. Obviously I'm not enamored of gold as investment, but trying to equate the value of bitcoin stock to the value of gold ignores both real consumer values for gold and the thousand year history of holding it as value.

The second method of valuing bitcoins - by relation to a company or other monetary store - is copied (with due skepticism) here. The rough idea is to try to equate the total value of bitcoins to market cap of Western Union, Paypal, or the monetary base of Turkey (I'm not making this up). Hopefully it is obvious to SA readers that comparing the aggregate value of a niche medium of exchange to the discounted cash flow of a functioning business is a bit odd. Western Union's aggregate 'exchange' was about 70 billion in 2012, considerably more than its market value. Further, if Western Union were to hold onto transactions in the mode of a commodity speculator, it would quickly be a worthless entity. Here recall that Bitcoin is an open-source computer system protocol which logs transfers of bitcoins - it is not a company taking fees. The protocol is intentionally distributed in nature and allows for competition in attempting to take transactional fees (meaning you too can join the competition). In my previous article I did suggest that bitcoin might (at the limits of imagination) replace a fledging national currency as a way to leap frog the process of joining more traditional (and more expensive) international financial systems. What I had in mind was Somalia or Laos - a far smaller entity than Turkey - who lack financial infrastructure.

The third mechanism, working out a value necessary to support transactions, strikes me as the most sensible approach. I take the approach from Guan Yang here. The basic concept is to estimate the value of all transactions on the Bitcoin network and then use that to calculate how much each bitcoin must be worth to support that transactional value. Thanks to blockchain.info we have some statistics to estimate from. For the last few months, the bitcoin turn over has been about 250,000 btc/day. That's on a total base of about 9.6 million bitcoins (11.9 million mined minus about 1.5 million lost minus another 0.8 million for Dread Pirate Roberts which the FBI is unlikely to confiscate). Again according to blockchain.info, at market exchange rates, that's about US$25million per day for the last few months, with a recent spike to $150million. Calculating for turnover, we get an average bitcoin velocity (rate of spending) of 1 bitcoin per 38 days. Clearly a good portion of bitcoins are held for speculation and not spent. That is further supported by seeing that trade volume is generally above 10% of transaction volume, and often much higher. What about the longer term though? I've compared Bitcoin to PayPal before, so I'll start from there. In Q3 2013, PayPal had $44 billion in transactions, or $176 billion annualized. That would be an enormous growth and wildly optimistic. Assuming today's supply and velocity (9.6 million bitcoins flowing at 1 bitcoin per 38 days), bitcoins would need to be valued at about $1,900 per bitcoin to support that load. If we assume that it takes 4 years to get there and a 10% loss of bitcoins we'd have 14.3 million bitcoins and a value of $1,275 each. However, if people hoarded bitcoins less and spent them faster, in theory bitcoins could be spent at a rate of 24 times per day each (a whopping 230million btc per day with the current stock), then the value in four years necessary to carry $176 billion in transactions would be just $1.39. All of that leads back to the inherent dilemma of a virtual currency - its value derives from use, but the more it's used the less scarce it is. If you invest in bitcoins you must consider the risk of bitcoin losing users and the risk of it gaining too many.

There are some reasons to be optimistic for Bitcoin use; though what it implies for bitcoin price is unclear. More real-world services are accepting payment in bitcoin: food delivery company Thuisbezorgd, and more dramatic apartments in Shanghai from Shanda which sold out in minutes. Also notable is the very quick growth of interest in China. I'm only speculating, but Chinese interest in alternative investments, getting around capital controls and the notoriously opaque central bank might give Bitcoin a loyal and potentially large user base.

There may well be considerable upside to bitcoin speculating. The China market, and the install base that could generate present a potential for Bitcoin to stick long term. But for now, I still stick to my earlier assessment, that Bitcoin has been a wildly successful experiment but the greatest risk is the next generation of the technology. Bitcoin was built to provide fast and cheap transactions - 10 to 60 minutes is a lot better than ACH. But already faster, and probably cheaper, payment infrastructures exist - such as Vocalink in England with transaction times in seconds. Ultimately I think that something heavily influenced by, but much better than Bitcoin will come along.

Source: Bitcoin Part 2: Valuation?