Bitcoin: Are You Getting What You Pay For?

| About: Winklevoss Bitcoin (COIN)

Summary

There is an honest debate if the nature of Bitcoin endows it with a fair value that can be estimated.

In an attempt to do so using a Quantity Theory of Money approach, we use educated assumptions to model a present fair value of $29,733 per coin.

Scenario and sensitivity analysis suggests there is more room for upside error than downside.

This analysis is based on the bold assumption that Bitcoin is viable in the long-term as a currency for global commerce.

Pay with BTC

Bitcoin and its cryptocurrency brethren are hot news and for good reason. Two good reasons, actually. First, the idea of a decentralized, non-governmental, global currency has captured the imagination of countless techies, libertarians and just plain curious folks. It's a novel species in the financial ecosystem with as yet undetermined consequences. Will it be a predator of national currencies or fall prey to the strong hand of government oversight? Secondly, the blockchain technology underpinning cryptocurrencies has far-ranging potential beyond the exchange of virtual currencies such as serving as a register for commercial contracts.

But let us consider Bitcoin as a financial asset. When a prudent investor contemplates purchasing (or selling) shares of a company or a government or corporate bond, there are metrics and models to help arrive at a fair value estimate of the asset which can be compared to the current price. If the fair value estimate is higher than the market price, the asset is thought to be undervalued and a good purchase candidate. Likewise, if the fair value is calculated as below the market price, the asset is considered overvalued. If we want to exchange dollars or euros for bitcoins, shouldn't we want to know if the price is more or less than the value we are receiving? Is it even possible to estimate?

Does Bitcoin even have a fair value?

There seems to be two distinct views on this question. In camp 1 are the analysts and pundits that believe cryptocurrencies such as bitcoin do not represent anything of value or that can be valued. Opinions in this camp range from the acerbic (Bitcoin is a sham, snake oil, fundamentally worthless, even fraudulent) to the more benign (Bitcoin only exists it the minds of those who believe in it, but is not backed by anything people can count on, so don't count on it) to the more pragmatic (the variables required to value Bitcoin are unknown or too indeterminate). But the common idea in this camp is that there are no fundamentals supporting Bitcoin or any other cryptocurrency so it cannot have a fair exchange value. Price is driven solely by speculation, a grand con-game based on the "greater fool" who will eventually get left holding the bag when it all ends in tears. There is no anchor for the price to gravitate towards so all you're dong when you buy it is hoping someone will buy it from you at an even higher price. A house of cards susceptible to the breeze of disruption from government interference, security scandals, hacks, thefts and a general failure of confidence.

Digital currencies are nothing but an unfounded fad (or perhaps even a pyramid scheme), based on a willingness to ascribe value to something that has little or none.
- Howard Marks, Oaktree Capital Group

National currencies have value, goes the argument, because they are the legal tender for exchange in a geographical area. They have the force of law behind them. If you travel to India, you can be confident you can exchange Rupees for goods and services. But there is nothing to compel your counterparty to accept payment in a given cryptocurrency. Like many merchants, maybe they accept Bitcoin today but there is no guarantee they will next week. The merchant support for Bitcoin can dry up without warning but no merchant in the US, for example, will stop accepting payment in U.S. Dollars.

The company you keep:

Camp 1 - The Bitcoin Bashers Camp 2 - The Bitcoin Bravados
Warren Buffett, Oracle of Omaha Peter Thiel, Venture Capitalist

Joseph Stiglitz, Nobel prize-winning economist

Christine Lagarde, Managing Director, International Monetary Fund (NYSE:IMF)
Jamie Dimon, CEO, JP Morgan Chase Haruhiko Karoda, Governor, Bank of Japan
Paul Krugman, Nobel prize-winning economist Bill Gates, Founder, Microsoft
Robert Shiller, Nobel prize-winning economist Richard Branson, Founder, Virgin Group
Ben Bernanke, Former Chairman of the U.S. Federal Reserve Bank Milton Friedman (by implication), Nobel prize-winning economist

Meanwhile, over in camp 2, advocates of the brave, new currency point out that cryptocurrencies can be and currently are exchanged for real goods and services, proving they are viable means of exchange, however limited their commercial use is at present. In this view, Bitcoin should, in theory at least, possess a fair exchange value similar to traditional currencies. In an increasingly unstable geopolitical landscape, national governments are seen to be more at risk of losing control of their currencies and cryptocurrencies will be poised to assume the traditional role of stores of value. Fingers point to Venezuela and Argentina as countries that have seen spikes in bitcoin transactions during periods of crippling inflation. Cryptocurrencies are a logical next tool of political economy in today's global, connected world where national borders are increasingly porous and irrelevant to commerce. The trajectory for cryptocurrencies are increasing stability, wider adoption and use, and legitimization by financial markets (think CME) and regulatory authorities (think Japan). Admittedly, many species of cryptocurrencies will certainly not establish a niche and fail to survive in an increasingly competitive ecosystem. Some will become the Homo neanderthalis of cryptocurrencies, existing for a brief time, leaving their mark, but ultimately displaced by better adapted cryptos. This camp sees Bitcoin as a survivor, the Homo sapiens of the cryptocurrency world.

Bitcoin is certainly something more than just a fad ... The concept of anonymous currency is a very interesting concept -- interesting for the privacy protections it gives people, interesting because what it says to the central-banking system about controlling that.
- James Gorman, CEO Morgan Stanley

What, then, is a bitcoin worth today?

Note: I have been using Bitcoin (capital B) to reference the system and concept behind the whole cryptocurrency. I will now also be referencing bitcoin (lower b) for the actual unit of currency.

If you are a denizen of this second camp under the proud banner of Bitcoin, then the question is pressing, what is it worth? What should you be willing to pay for a unit of bitcoin? If you want to treat bitcoin as a serious currency, this question must be addressed. Of course, as a currency, we need to decide what to denominate the value in, as all currencies maintain a relative value to each other. We will use the USD as the comparator for this analysis.

National currencies are usually valued by analyzing fundamentals such as differentials in inflation rates, interest rates, trade balances and economic growth with a comparator currency. But it may be inappropriate, if not impossible, to model a decentralized cryptocurrency that is designed to have global acceptance as one would a national, government-backed, currency. These factors simply do not apply to cryptocurrencies such as Bitcoin. As a candidate global currency, there are no comparators for a relative analysis. Theoretically, should we begin trading with an alien world using Bitcoin as our Earth currency, we could then perform a relative analysis against the Rigelian Rigcoin or whatever.

Bring your Bitcoin wallet when visiting other planets because Rigelians won't accept American Express.

cantina creatures

Source: Insidethemagic.net

However, we can make an attempt to apply the Quantity Theory of Money to derive a fair value of bitcoin as QTM is not a relative value framework. Instead, we find ourselves seeking to answer the question: what value of a unit of bitcoin (BTC), in USD terms, is required to support the economic activity traded in the currency?

Here we can try to adapt the Fisher exchange equation to our purposes.

M*V=P*T,

Isolating M, we have

M=(P*T)/V

where M is the money supply, V is the velocity of money, P is the average price of transactions and T is the volume of transactions. P*T is an estimate of the U.S. Dollar-value of the economic activity transacted in bitcoin, or as I am calling it, the bitcoin economy. Our goal is to estimate a fair value of BTC in USD terms, or USD/BTC, needed to support the bitcoin economy, which we extend to saying the supply of BTC in USD terms. To get this, we divide each side of the equation by the supply of BTC in circulation so our final equation looks like this:

USD/BTC = P*T/(V*M(BTC))

We are immediately faced with a problem. The bitcoin economy today is largely intractable and does not represent its potential. The astronomical rise in price this year encourages hoarding so today's commercial activity may understate activity that would occur in a more stable price environment.

The solution will be to model what a stable bitcoin economy may look like in the future and then apply a discount rate to derive a present fair value. This means we must make some assumptions and educated guesses about the parameters in question. This task is made all the more difficult considering the dearth of reliable data available. I hear the good folks over in camp 1 chortling already. Still, the camp 2 stalwarts soldier on.

Assumption 0: Bitcoin exists in 2040 as an established but limited global trading currency

Using the year 2040 as our benchmark when virtually all of the 21 million coins are expected to be mined, our first assumption is an existential one: that the Bitcoin project will come to fruition and still exist in 2040. We assume that bitcoin remains the dominant cryptocurrency of choice but must allow for other special-use coins and the gravest threat, national cryptocurrency systems that compete for transaction volume. We are also assuming that Bitcoin continues to overcome future scalability issues as was recently addressed with the SegWit2x protocol and that future hard forks in the blockchain ledger giving rise to competing currencies are largely prevented. If the recently spawned Bitcoin Cash (BCH) proves better adapted, we could easily see a quick migration from BTC to BCH and BTC could go extinct. Such is the ruthlessness of the cryptocurrency niche in the financial ecosystem.

Rumors of Bitcoin Death Have Been Greatly Exaggerated
- Roger Ver, Bitcoin angel investor, borrowing from Mark Twain

Assumption 1: Size of the global economy

We start with IMF data estimating the current global economy at $78 trillion. Projections for long-term global growth range by the IMF is about 3.5%. Price Waterhouse Cooper makes a more optimistic long-term estimate of 4% but we will use the IMF's number to be conservative. Of course, there will be a great disparity of growth between advanced and developing economies so we must also assume that Bitcoin use grows proportionally faster in developing economies as well. Indeed, it seems the developing, underbanked regions of the world are quickly adopting use of the currency.

Using 3.5% as our growth rate, we expect the global economy to be at about $172 trillion in 2040.

Underbanked nations are more likely to adopt cryptocurrencies for cross-border remittances and service payments.

Underbanked regions of the world

Source: www.mckinseyonsociety.com/half-the-world-is-unbanked

Assumption 2: Size of the bitcoin economy

But what percent of the 2040 economy will be supported by transactions in bitcoin? This is our most uncertain variable. We are assuming that there will be meaningful commercial use for bitcoin or we would not be going through this exercise but we must temper our expectations for the wide adoption of bitcoin for commercial use. My own personal view is that if Bitcoin survives to 2040, it will be in fierce competition with national cryptocurrencies that have adopted blockchain technology to complement, but not replace, their traditional monetary systems. Russia seems committed to developing their own cryptocurrency, the CryptoRuble, and even the U.S. Federal Reserve is giving the idea some thought. Some of these national cryptocurrencies could even be backed by real assets, giving them an advantage over bitcoin, such as what Venezuela is considering.

We fortunately have a fairly useful data point to build off of for our estimation. BitPay, the leading Bitcoin merchant payment service provider, announced they are on track to process approximately $1.3 billion in bitcoin merchant transactions in 2017. BitPay also represents about 60% of the market share for merchant clients as of 2015. The remaining being distributed between a troubled Coinbase, Coinkite and others. Assuming this roughly translates to 60% of merchant transaction volume, and allowing for a small number of direct wallet-to-wallet transactions among private parties for commercial transactions, we may be reasonably comfortable that the current bitcoin economy is in the ballpark of $2 billion. At 0.003% of the global economy, it is less than a rounding error.

Our assumption is strengthened when we compare to the common estimate that until the distorting price explosion this year, about 4% of blockchain transactions represented commercial activity. In 2016, average transaction volume was about $150M per day, or $55B annually, 4% of which is $2.2B, close to our estimate.

BTC Transaction volume

Source: blockchain.info

We can interpret the growing number of new wallets created and increase in unique addresses used on the blockchain to represent a growing base of potential commercial activity if and when the price action settles into a less volatile trajectory. We also will assume that the number of merchants accepting Bitcoin will continue growing to give Bitcoin an increasing commercial base to operate in. It would seem likely the Bitcoin commercial use rate will be quite low over the near-term then achieve the tipping point required to see a boom in use when the proof-of-concept stage gives way to rapid adoption. Obviously, the timing of this inflection point will be key. The main barriers payment companies say they need to overcome are difficulty in establishing banking relationships, compliance costs, and BTC liquidity in local currency.

Crypto Payment Challenges Source: Global Cryptocurrency Benchmarking Study, University of Cambridge Centre for Alternative Finance

Full report here: 2017-global-cryptocurrency-benchmarking-study.pdf

Some modeling suggests the geometric mean for the bitcoin economy growth rate over the next 20 years could be between 20%-40%. We will use 33.3% for our current valuation model. A 33.3% growth rate results in a $2.71 trillion bitcoin economy in 2040 representing 1.6% of the global economy

As a check, we can also try to make an educated guess at the size of the bitcoin economy in 2040 by looking at the economic sectors that are more or less likely to adopt bitcoin use and calculate their relative sizes. Using data from MSCI for the current percent of the global economy represented by commonly used market sectors, we then make judgements about how likely they are to see adoption of bitcoin as a transaction currency, and assign potential market shares based on that likelihood. Albeit a very back-of-the-envelope approach, the result suggests a $2.4 trillion bitcoin economy in 2040, representing 1.4% of the global economy and a thousand fold increase from today. These results are encouragingly close to each other.

Global Economy by Sector Source: MSCI, author

Assumption 3: Supply of bitcoin

This calculation is relatively straight-forward. By design, we know in 2040 there will be almost 21 million bitcoins mined, which is a hard cap. However, not all 21 million will be available for circulation. Chainalysis estimates around 2.56 million coins are lost for various reasons and will never enter circulation. They also consider the 1 million coins held by Bitcoin creator, "Satoshi Nakamoto" as permanently out of circulation. That is a big assumption and we may want to consider those "founder coins" as part of the bitcoin money supply but handicap the velocity of money (addressed next) for their likely slow release into the bitcoin supply. Given the anonymous nature of Bitcoin, it is anyone's guess if any of these founder coins have as yet been circulated, or will be by 2040. In the end, we will assume a supply of 18.5 million available coins in 2040.

Lost Bitcoin Source: Chainalysis, Fortune Magazine

Assumption 4: Velocity of bitcoin

The velocity of money refers to the turnover rate of the money supply or how many times a unit of money changes hands in transactions over a time period. It is an essential variable as less money is needed to support an economy if it has a higher turnover rate, or velocity. But a greater supply, or a higher valuation, will be needed if the velocity if lower. The velocity of a currency can be affected by many factors including structural factors such as transaction processing times.

Currently, it is no surprise that the velocity of bitcoin is extremely low given the hoarding and speculation mentality at present. But what will the velocity look like in 2040 when we expect a sustained bitcoin economy to emerge? By comparison, FED data shows that the velocity ratio of the M1 (cash and equivalents) supply of USD sits around 5.5, down from it's longer term average of around 7. We should not expect bitcoin to achieve this level of velocity. Expecting transaction times to improve, but not match the U.S. settlement system by 2040, accounting for wider use but significant hoarding to remain, including our discount for the founder coins, we may consider a velocity ratio of 2 to be a reasonable guess. That would represent quite robust adoption over the next 23 years.

FRED M1 velocity Source: FRED

Assumption 5: The discount rate

Using all of our previous assumptions for our model, we can finally calculate that to sustain a $2.71 trillion bitcoin economy, a supply of 18.5 million coins circulating with a velocity ratio of 2, 1 bitcoin will be fairly valued at $73,282 in the year 2040. But that represents the future value. What should we be willing to pay today for that future value? That is the question behind fair value.

We will apply a 2.5% discount rate, which approximates the long-term price of cash, but considering the uncertainty behind all of our assumptions, especially assumption 0, it may be prudent to add on an additional Margin of Safety to our discount rate. In my judgement, 1.5% is substantial without being overly punitive.

Finally, at long last, discounting back to present day, we arrive at a present fair value of $29,733 per coin. As of this writing, we can then judge bitcoin to be undervalued in the market. Lowering our margin of safety will increase the present fair value estimate to a maximum of $41,529.

BTC Valuation Model Obviously, this fair value estimate depends on the accuracy of the assumptions and I imagine my learned peers in Seeking Alpha will have a variety of differing opinions on each variable, some more conservative and many more optimistic. And that's just the camp 2 people! Camp 1 readers will simply dismiss the whole exercise as futile, unfounded and laughable.

Is the fair value estimate sensible or too sensitive?

So how sensitive is the analysis? Certainly our most uncertain variables are the future size of the bitcoin economy and the velocity at which bitcoin circulates. As Bitcoin is more widely adopted for commercial use, we can expect increased value of the currency but this value will be tempered by a faster velocity.

Scenario Analysis Our base case here assumes a 33.3% long-run adoption rate resulting in a $2.7T bitcoin economy with a velocity of 2. Using this as an anchor, we can also ask, what would a bear and bull scenario do to our fair value estimate?

In a bear scenario (but not apocalyptic), the bitcoin economy grows at a more muted 20% and velocity doesn't pick up above 1, hovering around 0.75. Bitcoin survives the existential challenge but struggles against national cryptocurrency and fork competitors that are accepted alongside the original BTC. In this scenario, the currency only accounts for about 0.15% of the global economy. Even under such conditions, the present fair market value is $7,505, a level already achieved within the past year of this writing.

In a bull market scenario, wide adoption of Bitcoin occurs relatively early and the bitcoin economy grows at an annualized rate of 45%. The limited supply helps increase the velocity ratio to 4 and in 2040 bitcoin commerce reaches $17.8T and represents a full 10% of the global economy. The present fair market value in this case is $97,665.

Other scenarios can also be evaluated in the below data table where we get a sense of the range the fair value can drift in under various scenarios. What is striking is that the fair value estimate does not drift too far if we imagine a less robust scenario where the bitcoin economy grows slower but velocity stays low, also, or more widely used with a higher velocity.

Scenario Data Table

Your own assumptions will likely vary from my own, sometimes wildly. I would love to hear how other people approach the problem of valuing Bitcoin.

As with any asset, using a fair value to make investment decisions requires patience and fortitude. Prices are likely to swing wildly away from fair value, until a greater number of analysts begin treating the currency like an investment and a consensus emerges that serves to anchor market expectations. Right now, it seems Bitcoin is not only unanchored but is being battered around by the full force of the gales of speculation.

The importance of fair value

In investing, we know good companies don't always mean good stocks. A good stock means the price is lower than what we think it's worth. And that depends greatly on what our future expectations are for the company. I have no strong commitments to either camp. I have questions about the viability of Bitcoin long-term but am humble enough before this revolutionary technology to know there is potential. I have no need at present to use Bitcoin commercially or as a cross-border payment rail, so I only look at it as a potential financial asset. But as an investor and not a speculator, I would want to assess a reasonable fair value before taking a position in it. If I can't establish a fair value, it's nothing more than taking a sucker's bet. My hope is to encourage more people to think through the economics of Bitcoin and converse about their expectations for the digital currency in a framework that encourages rational decision making.

BTD Gif

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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