I was recently asked about the value of bitcoin.
"What is it backed by," he asked. To which I replied,
"Currency. Your dollar."
"So how can I buy shares," he asked.
"You can just buy bitcoin. You invest by buying and using it."
"But what is it backed by," he asked again.
I wasn't getting through. This post is my attempt at a better argument.
Bitcoin can't be valued by traditional valuation methods like cash flow or P/E (I'll be publishing an article comparing bitcoin P/E to other cryptos shortly). Bitcoin has a unique business model. There is no CGS, SG&A, EBIT or EPS. There is no bottom line. The work has been fully automated and the process of creating these automated digital systems is done by the "bitcoin miners".
So what makes the value of bitcoin go up? What drives the value of bitcoin? When people use their local fiat currency to purchase bitcoin the value of bitcoin goes up. The more people that buy and use it, the more the value goes up, which means bitcoin's value is directly connected to its utility over fiat currency.
Bitcoin: The Value Proposition
Bitcoin's value proposition depends on the person. I see it as a way to improve the flow of resources around the world. I think of my investments in bitcoin as an investment in the front-runner of an emergent technology. For me, bitcoin is revolutionary and invaluable.
I have heard bitcoin described in many ways. It is many things to many people. For some, it is a global, decentralized banking system. It has no borders or nationality. It serves as a store of value, a digital currency, an off-shore banking account, a peer-to-peer payment system and a payment processor (back- and front-end). To investors, it is the world's fastest growing asset class. It also serves as a natural hedge against almost all other assets and is available, like gold, in limited supply.
Let's discuss how the sum of bitcoin's parts adds up.
Value Proposition #1: Global, Decentralized Banking System, Peer-to-Peer Payment System and Processor
When you swipe your Visa card or iPhone, the data in the magnetic strip is sent to a "front-end processor" (intermediary/checkpoint #1). The front-end processor forwards your information to the "card association" like Mastercard (MA), Visa (NYSE:V) or American Express (NYSE:AXP) (intermediary/checkpoint #2). Your information is sent to the "issuing bank" to verify the balance (intermediary/checkpoint #3). Approval is issued and that approval flows back to the front-end processor as a confirmation. Each intermediary or broker gets a cut. Bitcoin, by contrast, is a transaction from A to B, which greatly reduces the cost of the transaction.
The reduction of costs is a very powerful value proposition. That and ease of use are the hallmarks of disruptive automation technology and it's about time this kind of technology entered our system of payments. Bitcoin has automated the payments process, from one end of the globe to the other. All you need is a cell phone.
What is this worth? People often compare Visa to bitcoin, suggesting that bitcoin should have the same value. This is like comparing Netflix (NFLX) to Amazon (AMZN). Netflix is a digital powerhouse, but digital content is just one source of revenue for Amazon.
Translation: Bitcoin is a dynamic peer-to-peer payment system, but this is only one piece of the bitcoin value pie.
How do we go about valuing the entire pie? Before I get to that, let's look at a few other drivers.
Value Proposition #2: Limited Supply
When you increase the supply of an asset with a strong value proposition, the demand goes down, along with price.
When you decrease or limit the supply of an asset with a strong value proposition, the demand goes up, along with price.
You don't need a degree in economics to understand this relationship. The amount of currency on the market today is not in limited supply - it is created out of thin air when banks make loans. With $2 trillion in excess reserves (courtesy of quantitative easing), banks no longer have to worry about capital requirements.
Unlike our dollars, the supply of bitcoin is limited. The creator of bitcoin placed a cap on the number of bitcoin that can be created at 21 million and we are fast approaching that number. The current number of bitcoin stands at 16.7 million. What happens when we reach 21 million?
Translation: When bitcoin reaches its upper limit, the value will spike.
Limited supply is a powerful value proposition in a market economy.
Value Proposition #3: Currency & Store of Value (Bitcoin is Better Than Gold)
Technically, nations are supposed to pay all debts in gold (GLD). Thanks to the Bretton Woods agreement, dollars (^DXY) became the medium of exchange used to settle debts between nations, which strengthened this relationship and increased the dollar's supply around the world. The system was only made possible because of a guarantee by the US Treasury to redeem all dollars for gold. If foreign nations wanted to exchange dollars for gold, they could do so through the US Treasury. When this arrangement became inconvenient, the government reneged on its promise and the dollar crashed.
In August of 1971, with dwindled gold reserves, and a long line of budget deficits, President Richard Nixon terminated the convertibility of gold which turned the dollar into a fiat currency. Foreigners held nearly three times as many dollars as the US could redeem and were demanding gold because of lack of confidence in the US economy. The result, foreigners had to sell dollars in money markets at a discount.
When this happened, the US budget deficit was $11.6 billion. Nixon was worried the deficit would climb to $23 billion by year's end and he felt the need for drastic measures. Today, by comparison, the current budget deficit is $666 billion. The Trump Administration just passed tax cuts that will decrease revenues and push the deficit up even higher.
What we are about to experience is part of an inevitable cycle. This time instead of hoarding gold, people will buy bitcoin as both a store of value and a form of currency. It shares a few attributes with gold in that it is rare and available in limited supply. It is also highly useful in many different applications and you can find a market for it almost anywhere in the world. Unlike bitcoin, gold is heavy and requires a physical custodian so the cost of storage is high. It also doesn't come with its own payment system.
Translation: Bitcoin is superior to gold and the dollar in many ways which is why bitcoin topped the price of gold per ounce in March of 2017, closing at $1,268.
Value Proposition #4: Natural Hedge Against Inflated Assets & Off-Shore Banking Services
As bitcoin gains in popularity, especially as a "first-to-market" technology, banks will lose customers. Bank profitability will decline as the world "unbanks" by switching to a faster, cheaper, autonomous, automated, peer-to-peer payment system. Investors and hedge fund managers are already looking for other places to invest because everything is overvalued. Hedge funds would rather pour billions into bitcoin than over-leveraged, inflated assets. Here's a video of one hedge fund manager explaining how he values bitcoin:
Perhaps the most salient point to his argument is that institutional buying has just begun. I disagree with him on one point, however. Endowments and pensions are only about six months out from investing heavily in bitcoin, not 18 - a qualified custodian of bitcoin will likely emerge in this space by the end of March 2018.
Translation: Not only is the value of bitcoin going up around the world, but the value of the dollar (and all assets pegged to it) is going down. Investing in bitcoin poses little risk when used as a hedge in a portfolio full of assets that are highly correlated and overvalued.
Bitcoin's Potential Value: $4 Million/coin
The value proposition is clear and strong, but what is that value? Can we put a number to it?
Imagine we're sitting in a room together. On my laptop, I pull up the following chart (please go here to view the chart). This is the best illustration of asset values on the web. More specifically, it helps to put bitcoin and the entire crypto-universe into perspective against the world's assets.
Start at the top with Silver and Cryptocurrency, then work your way down to Derivatives. If that doesn't make you put bitcoin's potential value into perspective, I don't know what will.
How can you quantify this potential?
Bitcoin could take value away from silver and gold valued at $17 billion and $7.7 trillion, respectively. It may take value away from the global stock market (banks in particular) which has a market capitalization of $72 trillion. It may suck up all the world's currency (coin and bank notes) valued at $7.6 trillion, but this is only 8% of the world's total money supply. The true money supply, referred to as 'broad money', includes coins, bank notes, money market accounts, savings, checking and time deposits. It's all the money we "think" we have access to. The total amount of broad money in the world is $90 trillion.
It's hard to say which asset class bitcoin will impact the most. I think the drain will be felt by all, but the global money supply is the most vulnerable. In order to use bitcoin's other features, you need to convert your local currency, whatever it is, to bitcoin.
In addition to being a store of value, bitcoin also represents a way for people to hide money and protect it against asset seizure. Today, it is estimated that roughly $21 trillion sits in off-shore accounts.
Translation: Bitcoin has a value potential of at least $90 trillion, which we'll assume includes $21 trillion sitting in off-shore accounts.
We also know that the maximum number of bitcoin available is 21 million, which allows us to calculate the potential value of 1 bitcoin by dividing the total amount of broad money by the total number of bitcoin.
The calculation is $90 trillion divided by 21 million, which is approximately $4.3 million per bitcoin.
After you stop laughing I'll explain why I think this is an ultra-conservative estimate.
- All the money in the world does not capture the value of total assets.
- While bitcoin's volume is capped, the value is unlimited. The more it grows, the more money central banks will print fiat currency, which will be used to buy bitcoin.
- Bitcoin production is capped at 21 million, but studies show that 4 million have been lost forever so the true base may be closer to 17 million.
One thing is clear, if the rise of bitcoin can tell us anything, it is that people are losing trust in fiat money and other traditional measures of wealth. This is the mark of inflation.
We aren't seeing a rise in inflation with inflation statistics due to the rise in income disparity. As a result, there are two economies - one is hyper-inflated, the other is stagnant. Stagnant wages guarantees low inflation statistics even in a time when all assets are clearly inflated. It may not be that bitcoin is going up, but that all other assets are locked in an inflationary collapse and bitcoin is capturing that value. Meanwhile, the smartest minds in the world are on board Train Bitcoin. They're doing everything they can to make this open-sourced technology work. And, it's working.
Disclosure: I am/we are long BTC.
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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