Cryptocurrencies are one of today’s hottest asset classes to invest in such as bitcoin and ethereum. 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?
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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.
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.
As the Harvard Business Review describes:
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 supplyV is the velocity of money in a given time periodP is the price levelT 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)