Bitcoin Does Have Fundamental Value - But Just How Much?

Summary

• Long-run asset prices, including cryptocurrencies, reflect their fundamental value.
• Bitcoin does have fundamental value because it allowed people to transact in a way that was impossible before.
• The fundamental value of Bitcoin is the set of transactions that occur and are expected to occur on the Bitcoin protocol.
• While Bitcoin is undoubtedly useful to a set of users, it cannot make money as a corporation would or benefit its owners directly through buybacks.
• Nonetheless, $1B of value moves across the network on a near-daily basis. This means that, analyzing Bitcoin as a currency, it is actually trading close to its fundamental valuation within the 1-year interval.

It's a commonly accepted tenet within the capital markets that assets reflect their fundamental valuation in the long term. Within shorter time frames, it is more likely that assets will deviate from their fundamental value. While it is possible to profit off of mispricings such as these, using quantitative or momentum strategies, it is not a reliable strategy for the retail investor. For a retail investor who has considerations outside of the markets, including a family or completely unrelated career, it is best to stick to strategies which are bets on fundamental value. While this may sound surprising, it is possible to allocate capital on a fundamental basis within the cryptocurrency asset class.

This must mean that there is such a thing as fundamental value within the cryptocurrency space. While fundamental value within other asset classes is based on a set of present and future cash flows, there is no such offering within cryptocurrencies. Since stocks are shares of businesses that make certain amounts of money per quarter, you can value them 'fundamentally' according to a market-defined multiple of these cash flows and the predicted growth in these cash flows. In this way, fundamental valuations take consideration of future predicted cash flows for equities. Again, however, none of this matters for cryptocurrencies.

How can there be fundamental value within an asset class that does not generate cash flows?

The answer is that cryptocurrencies act as a platform, or protocol, for a set of users to transfer cash flows between each other.

The better a cryptocurrency allows users to transfer cash flows (value) between each other, the more fundamental value that cryptocurrency has. Of course, better depends on what your users want. Before Bitcoin was invented, users-to-be wanted Bitcoin: they just didn't know it yet.

When Bitcoin was invented in 2008 by Satoshi Nakamoto, the technology offered a viable implementation of something that people did want: a 'Peer-to-Peer Electronic Cash System'. Bitcoin offered the first code that actually worked to create a currency that was purely digital and could be settled completely peer to peer. The Bitcoin clearinghouse was a set of algorithms between the network of peers: a protocol. The biggest and most important of these algorithms, the one that would act as a ledger for everyone in the system, was named the blockchain.

This protocol, by allowing people to securely transact without a trusted intermediary, was useful to a variety of parties at the inception of Bitcoin. This is what first incentivized them to transfer hard currency for Bitcoin. Bitcoin was, and still is, a set of cryptographically-secure 0's and 1's. The transactions for hard currency that occurred, and still do, grant value to these bodies of information.

The problem with Bitcoin is that it isn't a company that makes money: it is a technology. Even as it evolves and does what it's meant to do, it cannot make money for people who own it. The Bitcoin technology is distributed and does not truly even exist as one entity: it is a constantly shifting mass of computers, called 'nodes'. There is no way that this entity can pay you a dividend or self-interestedly buy back Bitcoin to raise the price.

This means that the real fundamental value of Bitcoin is constrained to how much people are willing to pay to use the protocol to transact: it is the value of Bitcoin as a currency. The option to use the blockchain protocol, of course, is worth something: otherwise, the Bitcoin blockchain would not be growing in size every single minute of every single day.

As an investor develops this view and accepts the fundamental value of the cryptocurrency space, a lot more questions than answers come up. The most pressing of these questions is this: is the set of transactions that occur on the Bitcoin protocol really worth a market valuation of $300B?

Overview of Transactions on Bitcoin Blockchain

The market valuation of Bitcoin, just as with a stock, reflects both the current and future expected value of the instrument. Since we determined that the fundamental value of Bitcoin is based on the set of transactions that occur on the Bitcoin network, a rough fundamental valuation can be arrived at by looking at the transaction volume within a current time frame and estimating the transaction volume over a horizon. Let's look at the value of transactions on the Bitcoin blockchain over the past year:

Source: Blockchain.info (Direct scrape from Bitcoin blockchain, public data)

Although there is significant variability, it seems that about 80% of days see somewhere between 150k and 320k BTC moved across the network. To be more specific, I downloaded this data and summed it up: 98m BTC have been transferred on the network during 2017. At current valuations, this is a very significant amount of value transferred on the blockchain (98m * $16,000). However, most of these transactions occurred at BTC prices much lower than current valuations. Let's take a look at the rough transaction volume on the network priced in USD:

Source: (Blockchain.info, direct scrape from BTC blockchain)

As can be seen, the USD value of transactions occurring on the Bitcoin blockchain has seen a sharp uptick. Since a higher market value for Bitcoin means that transactions on the network become more valuable in terms of USD, an appreciating Bitcoin has resulted in much more value being transferred across the network. In late Q2 of 2017, the Bitcoin network had its first 'billion dollar day', in which the equivalent of a billion of USD moved across the network. For the last two months, most days have seen a billion, or multiple billion (in USD), move across the network.

The average amount of daily value moved across the network over the past year is $933,477,619 as of the time of this writing. Given the recent days having much higher weights, it is reasonable to believe this average will hit $1B by end of year. Thus, we can arrive at the very accurate estimate of $1B of value moving across the Bitcoin network daily over the past year.

Since roughly $1B of value moves across the network a day, a present market valuation of $300B is not irrational for the present. The real consideration here is the ongoing utility of the technology in the future. While for a stock, we may choose to 'price in' future expected earnings over 10 years, the cryptocurrency space is much faster moving. Just as the tech sector is more volatile and has more entrants, the cryptocurrency sector is even more so. Thus, a rational fundamental valuation should weight closer time intervals much more heavily than future ones.

How much value will move across the Bitcoin network over the next year and then onwards? While the current transaction amounts are significant, there are reasons to believe that this is not sustainable. The main reason for this is that the technology cannot scale too much farther; it is currently operating at or near its limit most of the time. This means that to move more value, Bitcoin must be worth more - not much more Bitcoin can be moved a day. This is evidenced by the rising transaction fees of the network:

Source: (Blockchain.info)

The technology is designed to increase transaction fees as the network becomes more strained; this creates a market dynamic where the most important transactions get executed and others don't. Nonetheless, the sharp spike in transaction fees acts to disincentivize people on the network. This rise in fees occurs because Bitcoin can only handle a certain amount of transactions a day. As can be seen, although the value of Bitcoin increased rapidly, the amount of Bitcoin transacted on the network stays roughly constant:

(Source: Blockchain.info)

This is because Bitcoin has a limited 'block size' and thus a hard memory constraint on transactions, allowing for only ~5 per second. Due to this, the amount of value that moves across the Bitcoin network can only go up if the price of Bitcoin goes up. The network itself cannot scale too much farther.

Conclusion

Here, we see proof that the Bitcoin technology is being used to move significant amounts of value on a daily basis. If we are to take the value of daily transactions, coming in at $1B USD and assume that for the following year, we arrive at a rough fundamental valuation of ~ $360B. This assumes a constant $1B of transaction value a day and only accounts for the upcoming year. The $1B is constructed from above data, and the one-year interval seems reasonable in this very fast-moving space.

Nonetheless, there are reasons to not accept this rosy valuation. If the price of Bitcoin were to decrease in the market, participants in the Bitcoin network would have to move more Bitcoin to move the same amount in terms of USD. This would strain the network further and increase transaction fees, which would disincentivize further transactions on the network - leading to less and less value moving across the network on a daily basis.

There is reason to believe this process will occur. Just like the technology sector, the cryptocurrency space constantly has new entrants with better features. Bitcoin technology is the oldest in the space and has not changed since inception: this cannot be said for agile competitors like Ethereum.

Pending further coverage, it is reasonable to conclude that Bitcoin actually deserves its current valuation for the immediate. Given concerns around its technology and immense set of competitors, as well technological sensitivity to fluctuations in its own price, this may not persist into the future. I will cover the rationale for individuals to either stay with the Bitcoin network or use an alternative in future articles.

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.