Valuing Bitcoin and Non-Income Assets

Bitcoin is a real-time momentum asset. We had a spectacular rise last year and crazy volatility this year and whipsaw trading as news flow now dominates price action. The best way to understand the asset price of BTC as an ultimate momentum vehicle driven by the sentiment of inflation and sentiment of technology adoption.

Here’s my fundamental thinking to understand BTC value. The key question for trading any non-income producing asset (as opposed to securities that have an income-stream, for example, bonds, equities, money) is to create some form of estimate or framework of value. I see two ways to look at bitcoin.

First is the analogy to “gold” analysis, i.e. an easy heuristic that BTC is at its core digital gold for the future. The “barbaric metal” (gold) has no income stream yet is valued as an alternative to fiat money. One way that most can justify a sky-high price of gold ($20,000+ / BTC) is assuming a portion of gold will be replaced by BTC. Assuming BTC can replace some portion of gold as part of our existing money system (roughly 8.2T gold market capitalization) we can assume some rough valuation (10% of this market cap and 22m BTC roughly translates to $40,000 / BTC.). This fundamental thesis does assume robust monetary infrastructure for BTC similar to gold with cash (i.e. gold / BTC to fiat currency) traders and brokers, derivative contracts and markets, and physical infrastructure for delivery (digital infrastructure in the case of BTC).
Drivers of value for gold include mainly the growth of economic money supply (which drives the “interest rate” of gold) and expected inflation (drives gold exchange value vs. fiat currencies). BTC then, will move in a similar fashion of money supply and inflation expectations if the fundamental infrastructure and usage is in place.

Second is fundamental supply/demand analysis, which we typically use for other commodities (such as copper, oil, etc.), where expected changes in productions and overall demand drive prices. For BTC and other crypto-currences there is one fundamental difference in that the supply schedule is fixed ahead of time. (BTC non-linear supply schedule implies supply growth of roughly 1% by mid-2020 with a cap of 21m BTC). Demand for its usage (i.e. value transfers or payments) can be modeled based on payment volume.

We estimate the notional transaction volume of payments where BTC may be used (online payments, remittances, micro-transactions, etc.)— and the % “share” that will be transacted with BTC. From there we can estimate the $ value of BTC in transactions. Since the supply of BTC is fixed (we assume what % BTC is freely traded float vs. hoarded to estimate the # of BTC) we can estimate an implied value of BTC using estimate $ transaction volumes and the BTC available. BTC’s transaction value can be estimated to be $6,000 / BTC to $17,000 / BTC, over time. (Assuming share of payments from 5% to 10%). (Note: I used analysis from Gil Luria from D.A. Davidson & Co.) If BTC is used for other payments (i.e. supply chain payments , trade royalties etc, or other areas of secure payments) the estimated value of BTC increase as the # of BTC needed goes up.

Inherent uncertainty in Bitcoin: more value = more security. Inherent to the BTC structure is a mechanism for securing transfers. Each transaction requires a # fee of BTC (which depends on supply / demand of transactions), which is rewarded to miners who check each chain of transactions to make sure they are consistent with other transactions. Since the value of BTC increase the profitability of BTC mining, it increases the # of miners. This does not increase the supply of BTC (as the schedule is fixed) but rather increases the security of BTC by increasing the “hash rate” or the computational load (computations required to a guess the mathematical puzzle and win BTC i.e. BTC “mining” while verifying transactions). This makes it more expensive for group of miners to “hack” bitcoin by dominating 51% of BTC hash rate to manipulate a transaction (i.e. single group “dominating” the consensus), and increases its security.

In order words, the security “value” of BTC increases with the $ value of BTC, as higher value of BTC draws in more miners, which increases hash rate and thus the security BTC. The “security” value also increases the $ costs (higher hash rate means computational power load). Likewise, as $ of BTC declines, reducing profits for miners, there is less # of miners and lower hash rate, or lower security value. As $ of BTC increases, more profits for miners, more # of miners and higher hash rate, higher security value. In other words, BTC is more secure as it becomes worth more and less secure asit becomes worth less. There is thus inherent uncertainty to its value as it security of the asset is tied to the demand or belief in the asset itself (since the $ value of BTC is essentially driven by the demand for BTC), especially as the infrastructure for either a gold-like use (analysis #1) or payment-use (analysis #2) is still being build. This is why hacks and similar security issues absolutely destroy BTC value (significantly reduces faith in the asset, which in turn reduces the actual security) while inflation and technology sentiment BTC skyrockets BTC value (i.e. the wave of inflation expectations and institutional interest in BTC technology late last year) as the price increases increase the actual security of BTC.

BTC is ultimate momentum vehicle driven by the sentiment of inflation and technology sentiment. Hence I’ve been out of BTC since early in the year. We can keep the price analysis from either analysis #1 (gold analogy) or analysis #2 (payment analogy) to estimate some “valuation” level. Ultimately its surprise inflation and recovery in technology sentiment, in my opinion, that will get BTC value increasing again. Until then, momentum reigns.

Investment analyst and biohacker