If you want to know what bitcoin is worth, you can’t start with stars in your eyes. Check around on the Internet and you’ll find arguments that every single bitcoin already in existence (over 14 million of them) could be worth $1m. It’s that kind of price action which attracts speculators.
But it doesn’t do you any good to buy on the hype. You’re better off examining what has driven the price in the past. Then, you make sure you understand, from a financial perspective, what bitcoin actually is. Finally, you can look at some simple models that will tell you what bitcoin is actually worth.
Some say bitcoin is money. Others believe it is the new gold. You will hear my thoughts on both of those possibilities. You will also see how bitcoin behaves like a technology stock because it has created a network which is growing.
Creative destruction for money
If you have followed my last three pieces in Capital and Conflict, you will already know that I believe blockchains will change the world of finance beyond recognition. Blockchains are smart contracts or cryptographic distributed ledgers (all pretty much the same thing). As electronic ‘bearer instruments’, they are the future of cash.
This entire subject came to be because of a man named Satoshi Nakamoto. No one knows who he actually is. Or if they do, they’re not telling. But the fact is, he released the bitcoin code on 3 January 2009. The rest is creative destruction.
It’s a shame we still don’t know who he is. He’s just been proposed for a Nobel Prize by Bhagwan Chowdhry, a professor of finance at UCLA. Whoever Satoshi Nakamoto is, he deserves a Nobel Prize. His idea is changing the world.
My colleague at Southbank Investment Research, Dominic Frisby, wrote a book about bitcoin. Dominic concluded that Satoshi is Nick Szabo, a computer scientist. Szabo denies it. But if it’s true, he’s rich. Szabo is thought to own over a million bitcoins, each and every one trading around $320 as I write.
For much of 2009, Szabo was the sole miner, a monopolist of sorts in an emerging industry. He was able to create new bitcoins before there was any competition. Few had heard of it back then and it hadn’t even started trading. Talk about first mover advantage!
Bitcoin has over 600 competitors that are attempting to create alternative forms of electronic money. The majority of them are flawed and, in some cases, ridiculous. But there are a dozen or so genuinely good ideas under development.
Turing’s children
These new ideas under development are described as ‘cryptocurrencies’. In the minds of their creators, the genius of each alternative currency lies in the cryptography. Cryptography is a complex area of mathematics with strong ties to Alan Turing. You wouldn’t be wrong if you described cryptocurrencies as Turing’s children.
Turing was known for his work at Bletchley Park cracking the German ‘Engima’ code. Winning World War Two was a team effort. But the contribution of Turing and his team should never be underestimated. The troops, the supply chain, the leadership, the Allies and the enemy’s economic limitations all played their part. Knowing the Nazis’ secrets saved many lives.
The geeks behind these cryptocurrencies see Turing as a demigod. They’re amassing small fortunes in his honour. Below $4.6bn bitcoin sits Litecoin, a younger copycat with slightly different code. The Litecoin network is worth $130m. Then comes Ethereum at $61m. After that, the network values drop off quickly.
Ethereum plans to change everything. It wasn’t even designed to be money, but a platform for great things. In short, Ethereum is a bitcoin-type messaging system with an ‘App Store’ sitting on top. If you’re not sure what that means, or why it matters, allow me to explain.
Turing complete
Its founder, Vitalik Buterin, has a brain the size of the planet. He states that his code is “Turing complete”. This is supposed to mean that it can solve any algorithm. Most of us have no idea what that means. If you’re like me, you imagine IBM’s Deep Blue beating Gary Kasparov and then square it a million times.
It is thought that the next generation of services such as Uber, Facebook or AirBnB could be built in a decentralised manner using this technology. These business models are relatively young, but already, the next generation of creative destruction waits in the wings.
Welcome to the world of open-source computing. Each year, hundreds of thousands of computer coders are trained. The creative ones want to change the world. With open source code, they don’t have to ask their boss for permission, they just do it. These kids of the future are bringing people together using networks.
These networks that they create can be built on top of cryptocurrencies. Bitcoin is the leader and has a tangible value because it is useful. According to Coindesk, there have been an estimated 12 million bitcoin wallets downloaded and 120,000 merchants have signed up to accept bitcoin as payment.
Valuing Bitcoin: Demand drives price
If something is growing in demand, what would you’d expect? If you have a basic understanding of economics, you know that when demand grows faster than supply, prices should rise. That brings me to an important question: what is the ‘price’ of bitcoin and where could it go?
Bitcoin trades in a free market. As a result, the price behaves somewhat rationally. Of course there is rampant speculation, but underlying that, the price reflects the potential and utility. But before you attempt to analyse bitcoin, you have to understand what it is.
Many call it money. But bitcoin is not money. When did you ever see money appreciate by 20,000 times? That happened when bitcoin first started trading in August 2010, to late 2013. Its lowest price was six cents and peaked at $1,200 just over three years later. That must be a world record for a security.
Bitcoin can’t be money. Why? Because money inflates as the supply grows. Instead, bitcoin was designed around the ‘idea’ of gold. It was lodged into the code that there would never be more that 21 million coins, all to be created by the year 2140.
Even though it’s a digital product, it has an intrinsic scarcity. That makes it behave a lot like gold, which is physically scarce. It requires labour, capital and time to produce gold (assuming you can find it first).
Halving process
Currently, there are just over 14,800,000 bitcoins in circulation. With new supply of roughly 3,800 each day, the annualised rate of inflation is 9.6%. This will halve in late 2016 because the miners’ reward falls from 25 to 12.5 bitcoins every ten minutes (1,900 each day).
This halving process occurs every four years. It’s lodged into the code and can never be changed. Bitcoin’s inflation rate over time will tend towards zero. Satoshi created this concept to limit the future supply. Without it, there could be an infinite number of bitcoins, just like there are air miles. You think you can fly to Barbados for free, but not when it suits you.
To put it another way, 70% of the bitcoins that will ever exist are already privately owned. If this network grows, demand will accelerate while supply growth can only slow. One investment principle that has stood the test of time is scarcity. If the bitcoin network grows, the price can only rise.
Bitcoin behaves more like a commodity than money. This is by design. Some believe that when the network matures, it could play a role similar to gold. With bitcoin worth just $4.6bn and the world’s gold worth over 1,000 times that, there’s plenty of upside should that ever come true.
It’s possible. But for the bitcoin network to grow in value, you’d have to see a total belief that the bitcoin system will have an eternal life (the way gold does). Even the bitcoin bulls have some doubts about that.
What if Skynet goes nuclear?
There are risks. For example, an electromagnetic pulse from a nuclear weapon would destroy most modern electronics. Dan mentioned this earlier in the week, in reference to the Terminator movies where an artificial intelligence named Skynet declares war on humanity and unleashes nuclear holocaust.
A man-made or computer-generated nuclear holocaust would certainly put a dent in bitcoin’s viability as a new method of exchange. But I would suggest that if you’re dealing with the fallout from an EMP attack, you’ll have bigger problems than falling bitcoin valuations. And in any event, the system has survived for nearly seven years without being hacked to death. Confidence is growing.
Warren Buffett famously said that bitcoin has no utility. Buffett is a legendary investor. But it doesn’t make him right about everything. Behind bitcoin lies a ‘public’ blockchain. This isn’t limited to sending and receiving value, as it can be used to send and store information. Surely that has utility, does it not?
That utility could be a ‘smart contract’ (coding the law), a message to a loved one (a couple registered their marriage on the blockchain), a reference to the provenance of a diamond (Everledger.io), or decentralised cloud-computing services. The list goes on.
Buffett spoke too soon when he said that bitcoin had no utility. Innovation in the crypto-currency space is rife. Innovation is a little like evolution. Lots of things get tried. Most fail. A winner adapts, succeeds and emerges. The marketplace imitates and ‘amplifies’ the genetic traits of the winner. That dynamic is what drives technological progress. That’s why I believe bitcoin will succeed.
Value in the network
Bitcoin is not money, nor is it a commodity. Perhaps instead, we should think of it as a technology stock. Like many valuable tech stocks, there are no revenues (unless you are a miner). And like social media, bitcoin brings together a growing network of people. The network creates the value.
In October 2014, the messaging system WhatsApp was sold to Facebook for $18bn. Many people saw that as a repeat of the tech bubble in the late 1990s. WhatsApp had nearly a billion active users. Do you realise how many people that is? In one single network, it brings together the majority of the world’s middle classes.
What’s that worth? How do you value it? Silicon Valley’s new social media companies embrace the network effect. In simple terms, every new user adds an exponential possibility of engaging with existing customers; something known as Metcalfe’s Law. The equation is n(n-1)/2, where n is the number of users.
If you have ten people for dinner, there are 45 potentially different conversational partners. That is assuming everyone speaks to each other. For a billion WhatsApp users, there are half a quadrillion communication possibilities. Once you have critical mass, as WhatsApp has, you will have cornered the market. It’s tough for new entrants after that.
Facebook’s attempt at messaging failed. That’s why they dug deep and bought the winner for $18bn. They couldn’t afford not to, and that was probably a wise decision. Now that they own the network on which a billion people trade messages, they can find a way to make money from it.
Value and an underlying utility
If bitcoin is a social media stock with additional benefits such as a store of value and an underlying utility, then maybe the current network value of $4.6bn is reasonable. It has the potential to dominate cryptocurrencies. Given the state of government-backed fiat money, cryptocurrencies may play a serious role in the monetary system one day. And that day may be sooner than you think.
In trying to value bitcoin, you have to decide whether it’s a currency, a commodity or a tech stock. It has elements of all three, but I believe the latter—valuing bitcoin as if it were a tech stock—is the most important because it recognises bitcoin’s utility. The value is derived from people using it. Not from what people think it should be worth.
Ultimately, if you’re going to invest in or get involved with them, you have to accept that crypto currencies are an emerging asset class in their own right. A crypto currency is simply a digital asset.
As a currency, bitcoin pays no interest. But it will have zero inflation before too long, thanks to the ‘halving process’. Currency valuation techniques normally look at the difference in real interest rates (interest rates after inflation) or purchasing power parity (comparative price of goods). Neither technique will work for bitcoin.
As a commodity, we can dream that it will sit alongside gold. In order to do that, it needs to appreciate 1,000 fold. Doing the maths, the fair value must be approximately $320,000 per bitcoin. Now, I’m not saying this is impossible. But it is, perhaps, a tad ebullient.
Value the network and the utility
If you’re valuing a tech stock, you need to value the network and the utility. Given the anonymous nature of bitcoin, you can only make estimates. We know that 12 million wallets have been downloaded. How many people actively use them?
We know there are 6,625 copies of the blockchain around the world, but don’t know why. We know from academic research (Soska and Christin 2015) that around $500,000 changes hands each day on the Darknet (drugs and so on). A similar level of activity takes place via Coinbase, a wallet provider.
I could keep going. But it’s unclear how to make sense of it all. Bitcoin doesn’t pay dividends today and never will. Even some tech stocks manage to do that eventually.
My preferred methodology is to consider bitcoin to be a crypto currency. In which case, the value lies in the size of the network, rather like WhatsApp. Tomorrow, in the final instalment of my five-part series, we’ll look at the growth of the underlying network and value it using all the data that is available back to inception in 2009.
The answer is rational and based upon facts. It helps to make sense of what is happening. I look forward to sharing these insights with you tomorrow. But be prepared, it will be somewhat technical so make sure you have fish for supper. If you missed the past three essays on bitcoin and the blockchain, you can read them here:
• Banks embrace the blockchain
• The future for electronic bearer certificates
Category: Investing in Bitcoin