Cryptocurrencies are one of today’s hottest asset classes to invest in. Bitcoin in particular has soared in price from pennies to thousands of dollars per unit in just a few years.
But is it all a bubble, like the Dotcom era or tulip mania? Or is this just the start of something bigger, or even revolutionary?
I don’t have the answers to those questions, but this article will provide a framework to help you think about how to value cryptocurrencies for yourself, including explaining a lot of the risks involved.
Start here from the beginning or jump to the section you want:
- Cryptocurrencies 101: A Blockchain Overview
- Bitcoin vs Fiat Currencies vs Precious Metals
- The Difficulty in Valuing Cryptocurrency
- How to Value Bitcoin & Other Cryptocurrency
Cryptocurrencies 101: A Blockchain Overview
Bitcoin, the first cryptocurrency, was invented by an anonymous person or group named Satoshi Nakamoto and released publicly online in 2009 as open-source software and a white paper that explains the concept.
Satoshi claimed to be a Japanese man in his thirties, but his identity has never been verified because all of his communication was via the Internet. He wrote with influences of British English, and had sleep/wake cycles according to his online activity that would presumably place him in North America, leading many to believe that he’s not actually Japanese. Or maybe he’s multi-ethnic.
It might not even be a man. It could conceivably be a woman or a group of people. But most likely it’s a man using a pseudonym. And wherever he is, he has about a million bitcoins, worth billions of dollars now, which he has never spent. And he has gone dark; after having invented the concept, he no longer leads it and his whereabouts and identity are unknown.
It’s like a good thriller novel.
Anyway, Bitcoin was invented for the purpose of being a decentralized currency and method of payment. It does not rely on any central authority like a government or bank or Satoshi himself, and is instead completely distributed on numerous clients running open-source Bitcoin software.
At the core of most cryptocurrencies is blockchain technology, which now has applications outside of just cryptocurrencies.
Contracts, transactions, and the records of them are among the defining structures in our economic, legal, and political systems. They protect assets and set organizational boundaries. They establish and verify identities and chronicle events. They govern interactions among nations, organizations, communities, and individuals. They guide managerial and social action.
The technology at the heart of bitcoin and other virtual currencies, blockchain is an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way.
With blockchain, we can imagine a world in which contracts are embedded in digital code and stored in transparent, shared databases, where they are protected from deletion, tampering, and revision. In this world every agreement, every process, every task, and every payment would have a digital record and signature that could be identified, validated, stored, and shared. Intermediaries like lawyers, brokers, and bankers might no longer be necessary. Individuals, organizations, machines, and algorithms would freely transact and interact with one another with little friction. This is the immense potential of blockchain.
In other words, blockchain is a new foundational technology that uses decentralized encryption to record events publicly. The technology was conceptualized in the 1990’s, but not implemented until Satoshi applied the idea to his Bitcoin software, creating a digital currency that relies not on governments or banks, but on encryption.
With Bitcoin, each user has a private key, which is a giant integer number that acts like a digital signature, and is kept secret, known only to that user. Users then have public addresses (more numbers), that people can send money to for the purpose of a transaction.
You don’t actually “store” bitcoins anywhere. It’s just a public ledger that attributes a certain number of bitcoins to addresses that you control with your private key.
Bitcoins can be “mined” by verifying the transactions of third parties. People can contribute computing power to verifying Bitcoin transactions, and in exchange, the algorithm allows them to create a certain amount of bitcoins for themselves. The total number of bitcoins will max out at 21 million, at which point they can no longer be mined.
Read more about the details of Bitcoin here, or check out this video of the technical details:
Since Bitcoin technology is open-source and not proprietary, other cryptocurrencies can be and have been created, and many of them like Litecoin even have certain advantages over Bitcoin itself, like faster processing times.
Another big blockchain application is for software. Ethereum, now the second largest cryptocurrency, was developed to be broader than Bitcoin in terms of using blockchain technology to transfer various types of value. It is like a decentralized app platform with a built in currency in units of ether. Typical app platforms have a central authority like Google or Apple, and developers can request to put apps on those networks to sell to consumers. Ethereum can do that without the central authority, without the middle man.
The “Banking on Bitcoin” documentary is a good resource to check out the history and details of cryptocurrencies.
Bitcoin vs. Fiat Currencies vs. Precious Metals
You might naturally be asking yourself what the potential advantages of cryptocurrencies are. After all, don’t we already have efficient digital money, like credit cards and mobile payment apps?
Historically, there are two types of money. Precious metals and fiat currencies. Cryptocurrencies are a new, third type.
For thousands of years across several continents, humans have traded valuable commodities as forms of value, to make bartering easier. Any material that has scarcity and desirability and that can be divided into small amounts works well enough, but gold and silver are the near-universal choices.
Gold in particular is rare and pretty, extremely resistant to reaction, and easily malleable into coins and bars, which made it pretty much perfect as a form of money, at least until the modern age. It’s no longer practical or even possible to walk around paying gold and silver for things you want to buy, unless government currencies go back to using a direct gold standard.
The main advantage that gold still has is that no government has price control over it. It has inherent value and scarcity all on its own, and is recognized everywhere. Investors view it as catastrophe-insurance, because it will always have at least some form of value and offers protection against inflation, fraud, and economic collapse.
Dollars, pounds, yen, and all other currencies are “fiat currencies”, which means they have no intrinsic value other than that a government has decreed that they are legal tender.
Fiat is Latin for “let it be done”. United States dollars have value because the United States government declares that they have value, and people have enough faith in the stability of that declaration to go along with it.
Fiat currencies are convenient, but not without risks. When a government fails, its fiat currency typically hyper-inflates into being worthless. Most fiat currencies ever created have eventually become worthless; the ones that exist now are all fairly recent.
Bitcoin was invented to be like a new, modern form of gold and silver. Like some libertarian sci-fi form of money.
It’s digital, and can be used for both in-person transactions and online transactions, assuming both the buyer and seller have the technology and willingness to use it.
It’s decentralized, meaning its existence and value is not tied to any agency, government, corporation, or bank.
It’s able to be broken into tiny fractions. You can send someone 0.008235 bitcoins, for example.
It’s fairly secure, as long as you protect your private key. Bitcoin uses a level of standardized encryption for which even the top supercomputers would take far longer than the current age of the universe to break. The core algorithm is quantum hard, meaning that even theoretical quantum computers of the future won’t be able to break the blockchain itself and alter it. However, the ability to find specific private keys may one day be possible by quantum computers but there are already steps being taken that would make that very difficult.
It can’t be tracked or regulated easily. Although all transactions are on the public ledger, there are steps to distance the user from the transaction, making Bitcoin transactions difficult to trace.
You don’t have to trust organizations with your private details. To buy with a credit card, you have to give your credit card info, and occasionally those databases get hacked. But to buy with bitcoins, you never have to give anyone your private key.
For these reasons, Bitcoin and other cryptocurrencies share some characteristics with precious metals. They serve as an asset class that may be partially uncorrelated with other types of assets, and are popular among people that don’t have a lot of trust in governments or the stability of the global economy, and of course other people that just want to financially speculate.
Unfortunately, this also makes cryptocurrencies perfectly suited for criminal activity. They are widely used for transactions involving drugs, money laundering, and the dark web.
The Difficulty in Valuing Cryptocurrency
Most buyers and sellers of cryptocurrencies are speculating, meaning they are just looking at price charts and guessing that it may go up or down with technical analysis.
Fundamental investing, on the other hand, uses a bottom-up approach to find the inherent value of something. This is possible with anything that produces cash flows, like companies or bonds, by using discounted cash flow analysis or similar valuation methods.
But when something doesn’t produce cash flows, like commodities, it gets trickier.
In my article on precious metals, I described how there are numerous ways to determine an approximate value for gold and silver, even though they don’t produce cash.
You can, for example, consider how much money it takes to mine those metals out of the ground per ounce, which has significant effects on the supply/demand balance of them.
You can also compare the long-term (multi-decade) inflation-adjusted price of gold and silver, to see how they have changed in purchasing power over time.
Lastly, you can compare them to other commodities, like the gold-to-oil ratio.
There’s no one answer for exactly how much a precious metal or other material is worth, but what those methods can give you is a reasonable range for where the price should be, and helps you identify the specific assumptions you need to make for certain valuation estimates to be correct.
And what makes all of these valuation methods remotely possible is that gold and silver have inherent scarcity; there’s only so much that can be economically mined. In fact, the total volume of all gold ever mined can be fit into a cube of less than 25 meters on each side.
Likewise, any individual cryptocurrency is scarce. For example:
- Bitcoin’s algorithm limits it to 21 million bitcoins total.
- Bitcoin Cash’s algorithm limits it to 21 million bitcoins total
- Litecoin’s algorithm limits it to 84 million litecoins total.
- Ethereum’s algorithm limits it to 18 million new ether per year.
- Ripple’s algorithm limits it to 100 million ripples total.
The problem is that although the units of any individual cryptocurrency are scarce, unlike precious metals there is no scarcity at all when it comes to the total number of all cryptocurrencies that can exist. Any programmer can make his or her own cryptocurrency, with the hard part being that it’s worthless until enough people recognize it, adopt it, and begin to trade it around.
Here’s a list of all current cryptocurrencies. There’s over a thousand of them!
Currently, there are eleven cryptocurrencies that have over a $1 billion market capitalization. But really, Bitcoin and Ethereum are the two that are far in the lead in terms of adoption. Bitcoin has over 55% market share, Ethereum has another 15%, and Bitcoin Cash (a hard fork of Bitcoin) has another 10% market share.
Cryptocurrencies will only be worth serious money over the long term if they take off as a method of spending and a handful of cryptocurrencies continue to make up most of the market share, rather than all cryptocurrencies becoming extremely diluted.
Even during the few days of writing this article, a block size update was cancelled for Bitcoin, which led to a sell-off resulting in a 20% decline in Bitcoin prices and a huge surge in Bitcoin Cash prices, although it’s not a problem for people who continued to hold both currencies after they split.
A big debate right now is what the block size should be. Small block sizes greatly slow down the network and make a currency unscalable, while big block sizes require bigger data centers to process, meaning the currency’s network can become highly centralized, which is exactly what users don’t want to happen. A solution in development is to process transactions off the blockchain and then reconcile them with the blockchain, like batching multiple transactions into one big transaction.
All that debate around block sizes and off-chain scaling solutions, plus all the other features of certain currencies, makes it challenging to predict which currencies will end up with dominant market share. Which ones will solve all the primary problems in the best way, and achieve the widest adoption?
These currencies are volatile, their market share is fickle, and updates can result in split currencies, which has happened to both Ethereum and Bitcoin.
How to Value Bitcoin & Other Cryptocurrency
Now that we’ve established what cryptocurrencies are and why they are difficult to value, we can finally get into a few methods to approach cryptocurrency valuation.
There’s no way to determine a precise inherent value, but there are certain back-of-the-envelope calculations that can give us a reasonable magnitude estimate for the value of bitcoins or other cryptocurrencies based on certain assumptions.
The trick, of course, is coming up with reasonable assumptions. 😉
Method 1) Quantity Theory of Money
The century-old equation to value money that anyone who ever took a macroeconomics class has learned is:
MV = PT
- M is the money supply
- V is the velocity of money in a given time period
- P is the price level
- T is the transaction volume in a given time period
If you double the money supply of an economy, and V and T remain constant, then the price P of everything should theoretically double, and therefore the value of each individual unit of currency has been cut in half.
The majority of mainstream economists accept the equation as valid over the long-term, with the caveat being that there’s a lag between changes in money supply or velocity and the resulting price changes, meaning it’s not necessarily true in the short-term. But the long-term is what this article focuses on.
If you know any three of the variables, you can solve for the final one. In other words, we can rearrange it into:
P = (M*V)/T
From that point, P will give us the inverse ratio of Bitcoin to whatever currency we use for our T variable. In other words:
Bitcoin’s Value = 1/P = T/(M*V)
The total number of bitcoins in existence (M) is a little under 17 million in late 2017, and it will max out at under 21 million over the next several years based on its algorithm. That’s the easy part.
Now we have to come up with estimates for V and T, which is the hard part.
Let’s start with a velocity example. Suppose you had a town of just two people, a farmer and a carpenter. The only money in the town is that the carpenter has $50. If, in the course of the year, the carpenter buys $30 in carrots and $20 in tomatoes from the farmer, and then the farmer pays the same $50 to the carpenter to build a fence around her property to keep pests out, then a total of $100 in transaction volume (economic activity) has occurred. The money supply is $50, and the velocity of money is 2.
The velocity of the United States M1 (highly liquid) money supply (shown here) hit a high of over 10 in 2007 and is now a little over 5.
The velocity of the United States M2 (moderately liquid) money supply (shown here) hit a high of 2.2 in 1997 and is currently at less than 1.5.
Currently, the velocity of Bitcoin is a little bit under 3% per day on average, or about 10 per year (1,000%).
That seems reasonable, but the problem is that a large portion of this velocity is just trading volume, not spending volume. For a healthy currency, the vast majority of volume is from consumer spending, with only a small percentage of that volume involved with currency trading.
Bitcoin however has a significant percentage of it just being moved around by speculators, rather than people going down to their coffee shop and buying a cup of coffee with some Bitcoin fractions. There’s no way to know what percentage is moved around for spending compared to what percentage is moved around for trading/speculation.
But anyway, we have actual velocity, even if the number itself is questionable, and we have what the typical velocity range of a major fiat currency is. When I value Bitcoin, I will use a range for the velocity value to imagine a few different scenarios.
The final (and hardest) part is T. This is the variable that represents the actual value of goods traded in bitcoins per year.
Let’s start with criminal activity, since that’s one of Bitcoin’s biggest applications unfortunately.
PwC estimates that global money laundering is $1-$2 trillion per year.
According to CNBC, the United Nations estimates that the global drug trade is worth $400-$500 billion per year, and that organized crime in general clocks in at $800-$900 billion, with much of that figure coming from their drug trafficking.
Most broadly of all, this research paper estimates that the global black market is equal to about 20% of global GDP, or about $15 trillion annually.
If we imagine right now that 10% of the global black market economic activity occurs in Bitcoin and nobody else uses Bitcoin, it would mean $1.5 trillion in goods/services is exchanged Bitcoin per year, which would be immense.
Going back to the Bitcoin = T/(M*V) equation, if M is 17 million bitcoins in existence, and we use V as 10, and T is $1.5 trillion, then each bitcoin should be worth about $8,800. Let’s call that an unrealistic high end estimate.
- If T is $500 billion and V is 10, then each bitcoin is worth under $3,000.
- If T is $100 billion and V is 10, then each bitcoin is worth under $600.
- If T is $10 billion and V is 10, then each bitcoin is worth under $60.
I’m going to argue in my next section that the transaction volume of Bitcoin is on the bottom end of that range. It’s nowhere near $1.5 trillion, and probably not even a tenth of that.
Now, black market activities aren’t the only use of Bitcoin. Virgin Galactic accepts Bitcoin, as does Microsoft, Overstock.com, and Expedia for hotels, plus other companies listed here. But it still seems more of a novelty at this point.
Besides estimating the current value of bitcoins, we can estimate the future value of bitcoins.
Suppose that cryptocurrencies really take off, and in ten years, 10% of global GDP trades hands in cryptocurrencies, with half of that being in Bitcoin. At about 2% GDP growth per year, the global GDP in ten years will be about $90 trillion USD, which means $9 trillion in cryptocurrency transactions including $4.5 trillion in Bitcoin transactions per year.
If T is $4.5 trillion, M is 20 million bitcoins in existence by then, and V is 10, then due to the Bitcoin = T/(M*V) equation, each bitcoin should be worth $22,500 by then.
And here’s a bearish scenario. If Bitcoin drops in market share to just 10% of cryptocurrency usage, and cryptocurrencies only account for 1% of GDP in ten years, and M is 20 million and V is 10, then each bitcoin will be worth about $450.
And I mean, it could drop to zero if its usage totally collapses for one reason or another, either because cryptocurrencies never gain traction or Bitcoin loses market share to other cryptocurrencies.
Here’s a table I put together that shows what each bitcoin should be worth in the future with a matrix of different velocity and global annual transaction volume figures in USD. Velocity is on the horizontal axis and transaction volume is on the vertical axis, with the money supply being constant at about 20 million in the near future:
As you can see, there’s a huge range for what bitcoins should be worth in the coming decade or so, depending on how much economic activity they eventually become used for and what the velocity of the coins is.
If you stick to a velocity of 5 or 10 and look down those columns, you can then just focus on what level of economic activity you expect Bitcoin to be used for in the next decade, which will give you a rough idea of what it might be worth at that time.
Method 2) National Currency Comparisons
Now, let’s keep it a bit simpler by not worrying about monetary velocity. Let’s just compare cryptocurrency adoption compared to fiat currencies as a rough order of magnitude sanity check.
The CIA World Factbook has a list of the size of the M1 money supply of each country, converted to USD. China is at $7 trillion, the U.S. is at $3.2 trillion, Canada is at $637 billion, Singapore is at $119 billion, etc.
Here’s the top 40:
Right now, all cryptocurrencies together are worth about $200 billion, with Bitcoin alone accounting for $115 billion. That makes it equal to about the M1 money supply of Singapore ($119 billion USD), a country of almost 6 million people and a $300 billion GDP that uses the Singapore Dollar as their medium of exchange.
This chart gives an idea of the active user base of Bitcoin, since the ledger is public. There are about 4.1 million accounts (addresses) with over $100 USD worth of bitcoins, of which only 1.7 million have over $1,000 USD worth of bitcoins. And users can have multiple accounts, so the total number of active users is probably under a million. For reference, the Bitcoin subreddit has about 400,000 subscribers.
Coinbase, a large Bitcoin, Litcoin, and Ethereum wallet provider, claims to have 12+ million users and 47,000 merchants. Compared to those other figures available, I suspect that most of the “users” never funded their account after creating it, meaning most of them are not real users.
And then we’re back at the question of how much economic activity (the equivalent of GDP) that actually occurs in Bitcoin from these million or fewer active users. How much of the $400 billion+ global annual drug traffic market uses bitcoins? Or how much of the $15 trillion global black market? How much legal economic activity is occurring in bitcoins? It’s difficult to say.
Considering there are far fewer active Bitcoin users than Singapore citizens, the average Singapore citizen is quite well off, and most Bitcoin users probably only do a portion of their economic activity in Bitcoin, I find it extremely doubtful that there’s anywhere near as much economic activity in Bitcoin as in Singapore’s $300 billion economy of six million people.
But it could be a tenth as much, which means the value of all bitcoins together could be about a tenth as much as Singapore’s money supply. That implies Bitcoin is heavily overvalued right now, as it’s collectively worth over $100 billion but should be worth maybe a tenth of that.
If 500,000 people do an average of $10,000 in Bitcoin economic activity per year (not trading, just actual spending), that would only be $5 billion in actual Bitcoin economic activity. That’s a tiny fraction of Singapore’s economy, far less than even a tenth, and Bitcoin’s total value would be a tiny fraction of Singapore’s money supply (just a few billion dollars worth), meaning each bitcoin should be worth like a hundred bucks and it’s currently grossly overvalued in tulip territory.
However, one argument for why Bitcoin is worth more now than it should be based on its estimated current economic activity, is because some people expect its adoption rate to go up quickly.
Suppose for example that within 10 years, Bitcoin surpasses Canadian dollars in terms of economic activity to become a top-ten world currency. Canada has 36 million people and a GDP of $1.5 trillion, their M1 money supply is worth over $600 billion, and their M2 money supply is worth over $1.3 trillion.
If there are 8 billion people in the world in ten years, and 5% of them use Bitcoin, that’ll be 400 million Bitcoin users. If the average Bitcoin user does only 10% of their economic activity in Bitcoin and 90% of their economic activity in typical currencies, then that’s the equivalent of 40 million people using Bitcoin for 100% of their economic activity, or roughly the size of the Canadian economy assuming similar average per-capita economic activity.
If Bitcoin’s reasonable market cap becomes worth, say, $600 billion in that scenario (comparable to Canada’s M1 money supply), and there are 20 million bitcoins in existence by then, each bitcoin would be worth $30,000. That’s a bullish scenario, but not impossible. It explains why some people are willing to pay several thousand dollars per bitcoin today.
Lastly, let’s compare Bitcoin to gold.
All the gold in the world is worth approximately $7.5 trillion, based on the World Gold Council’s estimate of how much gold has been mined and what the per-ounce price is.
If Bitcoin achieves 10% of the global value of gold ($750 billion) over the next 10 years and the number of bitcoins at that time is 20 million, then each one will be worth about $37,000.
If Bitcoin only achieves 5% as much global value as gold, it’ll be less than $19,000 per bitcoin.
If Bitcoin collectively is only worth 1% of gold, then each one is down under $4,000.
Personally, I prefer precious metals to cryptocurrencies when it comes to alternative investments.
They have thousands of years of reliable history, and each precious metal has scarcity and inherent usefulness. They are all chemically unique, especially gold, and there are a very small number of precious metals that exist.
Cryptocurrencies on the other hand, while each one does have scarcity, are infinite in terms of how many total cryptocurrencies can be created. In other words, there is a finite number of bitcoins, a finite number of litecoins, and a finite growth rate of ether, and so forth, but anyone can make a new cryptocurrency.
What this means is that even if cryptocurrencies become popular in usage, they could become so heavily diluted by the sheer number of cryptocurrencies that any given cryptocurrency only has a tiny market share, and thus not much value per unit.
Right now, Bitcoin, Ethereum, and a few other systems have most of the market share. If cryptocurrencies take off in spending usage worldwide, and a small number of cryptocurrencies continue to make up most of the cryptocurrency market share, then it will likely be the case that the leading cryptocurrencies remain valuable, especially if you hold onto all coins when hard forks (currency splits) occur.
Blockchains are an extremely useful technology, and cryptocurrencies based on blockchain technology do have a lot of reputable applications as a means of global exchange.
The engineering method of problem-solving is break a difficult problem into several small parts and then solve them individually, or realize that certain parts are unsolvable and to identify which assumptions need to be made. The benefit of this article is that it quantitatively shows which assumptions are necessarily to justify various cryptocurrency valuations.
Here’s what it takes to come up with a reasonable forward-looking valuation estimate for a given cryptocurrency:
- Understand the numbers and growth rates of how many units can exist in that cryptocurrency. That’s easy.
- Estimate how much economic activity will occur in total blockchain cryptocurrencies in maybe 10 years. That’s hard.
- Estimate how a given cryptocurrency will change or retain market share of total cryptocurrency usage. That’s hard.
- Compare those spending patterns to other monetary bases as a sanity check, or take into account velocity of money. That’s easy.
Basically, it takes a lot of assumptions to determine anything close to an inherent value for units of any given cryptocurrency. I don’t know to what extent cryptocurrencies will be used for spending in the next 5 or 10 years. And I don’t know which cryptocurrencies will have the dominant market share over time, or if they’ll all be diluted.
But I recognize the largest cryptocurrencies as a reputable (albeit extremely risky) alternative asset class at this time, and it may be worth having a very small portion of a portfolio allocated to a basket of them.
Based on the estimated number of current users and current spending activity (inferred from the number of known addresses, volume information, and so forth) when applying the quantity theory of money, Bitcoin seems greatly overvalued. Bitcoin’s market cap is in the same ballpark as Singapore’s M1 money supply, even though it has far fewer active users and probably far less economic activity per user.
But considering where this technology could go within the next decade and the prices that bitcoins could reach if certain bullish outcomes occur, I don’t consider it tulip mania either for those that truly believe this could become a major global currency. I can at least see a rationale there and the most optimistic numbers do support their thesis.
Bitcoin values could go up by a lot, or they could fall to nothing, and it mostly comes down to how much and how fast Bitcoin or any of these cryptocurrencies can achieve widespread spending usage, if any of them ever do.
Right now, there’s already a lot of optimism backed in; bitcoins and other major cryptocurrencies are extremely expensive compared to their estimated current usage. Investors are assuming that they will achieve widespread adoption and are paying up accordingly. That means investors should apply considerable caution.