What are popular value investing methods for bitcoin? How to determine Bitcoin’s value!

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How can we measure the value of bitcoin in order to make an assumption if it’s overpriced or underpriced and if we can use that valuation method to estimate a price direction in the near or longer term future? In traditional asset classes there are many established methods of measuring the (intrinsic) value. Years and years of study have resulted in reasonably reliable metrics that can be used.

For example for real estate the assessment is based on a calculation model that takes account for location, building costs, used materials, age, physical measurements etc. Also prices in the near area for similar real estate can be taken into account.

For stocks we take into account the industry as a benchmark, the company’s management, the company’s assets, the company’s results. The revenue and earnings projection are used in various models of value investing to place the “real” value of the stock against the actual price on the stock exchange. We then know if we are paying a premium or a discount for the stock and if we may assume the future price direction because of our analysis.

Commodities like gold and silver are less easy to measure their underlying value as they are not income producing assets nor have underlying assets tight to it like stocks, as they are the asset in and out of itself. As for use as an ingredient for products it is only used very limited, its physical limitations as a practical medium of exchange are limited, especially in today’s advanced environment, and it is for the largest part used as a store of value. Its price can’t be pegged to anything other than what the market forces of supply and demand dictate. Its perceived value is based on thousands of years of price discovery.

Bitcoin as an asset resembles because of its characteristics the most to a commodity type as gold. Bitcoin is not a company with a balance sheet of asset holdings nor has it a revenue stream on which we project its value or price. Unlike gold it doesn’t even have a physical use case like jewelry or as an ingredient for electronics. Its distributed ledger with limited entries (the limited amount of Bitcoins that ever will be mined) forms the store of value aspect similar to gold. However Bitcoin does offer something unique as an underlying value and that is its decentralized, permissionless (anyone can participate without permission), censorship resistant, mathematically secured and global payments network in which bitcoin serves as its native currency. This can be seen as the underlying value of the commodity that is Bitcoin; Bitcoin and its blockchain network are inherently tight together.

However Bitcoin is as an asset and as a commodity extremely young in its 10 years of existence compared to the 100s of years that shares exist and 1,000s of years that gold exists. For these assets infinitely more data and studies are available upon which reliable metrics have been found and price discovery has been taking place to develop a reasonable set of valuation models. Not so much for Bitcoin. But despite that, many initiatives are being explored to try to come up with models to project some sort of value on Bitcoin to estimate if the current price is or isn’t in balance and if it isn’t, what direction of price to expect. Because of the lack of time and data, a lot of assumptions need to be taken and by trial and error the best fit models of price analysis are being tested on reliability. No perfect science here yet, though some promising aspects and theories are emerging.

Let’s take a look at some of these methods that could be used as valuation model for Bitcoin and try understand their potential merits or make them help putting things in a better perspective whenever we compare the price of Bitcoin. Finding a reliable way to measure the true value of Bitcoin might help to bring the price valuation into a tighter framework so that the market price has something to peg itself to instead of the rampant speculation that we have currently because really nobody actually knows how much 1 Bitcoin is truly worth.

Popular (theoretical) methods that currently exist:

  1. Technical Chart Analysis: supply and demand
  2. Metcalfe’s law: Network Value
  3. NVT Ratio: Network Value vs transactions
  4. Sentiment (google’s trends, social media sentiment)
  5. BMI: Bitcoin Misery Index
  6. Methods based on the cost of mining
  7. Logarithmic Regression
  8. MV=PT

Technical Chart Analysis

This is the most basic form of valuation of Bitcoin, because it involves its ultimate value determination: it is what we as people decide what it’s worth (just as we decide how much gold or the US dollar or any other currency are worth) and that is determined where supply and demand come together in a free market place and the market participants agree on each price at each given time bitcoin changes ownership. The market price reflects the aggregation of (informed and uninformed) opinions, emotions, calculations, needs, hopes and fears at any given moment. The price development shows the actions that result from that aggregation and Technical Chart Analysis is the measurement tool that is used to interpret the footprint of the emotions and intentions from all those market participants to form an educated estimation if the market is considering the asset (Bitcoin) overvalued, undervalued, the trend where it is currently going and when and where it that trend might be reversing to correct itself. Many techniques and many theories are in the Technical Chart Analysis toolbox and time will tell which of those apply the best on Bitcoin based on statistical evidence over time. Techniques include trend analysis based on moving averages, Chart patterns, candlestick patterns and theories as Elliot Waves, Wycoff and more recent studies about Hyperwaves.

Can we use Technical Chart Analysis as investors to value Bitcoin and base investment decisions in Bitcoin upon it? Well, sure that is possible although trial and error will be the costly teaching school in finding the right strategy, interpreting patterns correctly and to execute on that strategy competently in order to be profitable based on Chart Analysis. It is a skill that is not for everyone and requires a lot of determination to learn the necessary theoretical, practical and mental skill set to be a successful trader/investor based on Technical analysis. However, it is certainly a good start in the process of understanding the valuation of Bitcoin to understand the mechanics of the market, how the price is established there and how different market forces and sentiments influence price behavior and direction. Building this sense will provide more insight and confidence in how you personally interpret the valuation of Bitcoin at different levels in different point in time.

Metcalfe’s Law: Measuring Network Value

Another way of looking at the intrinsic value of bitcoin is similar to how people value a network; networks as in telecommunication (telephone, fax, internet), social networks (Facebook) or even payment networks (Paypal). And bitcoin has a little of all those 3. For this valuation model people have been trying to use Metcalfe’s Law. This law describes that a network’s value is derived from the number of connections that it can make, which depends on the number of users (or devices) connected to that network; the number of connections and the value of the network increases exponentially when the number of users (or devices) increases. Simply put, the formula of Metcalfe’s Law is: n², where n = the number of connected users/nodes.

Network effect of Metcalfe’s Law

The example picture with phones here clearly shows that the intrinsic value increases when more nodes are connected. And it turned out that equally the value of the network can be assumed correlated to the number of connections that can be made. Best proof for this was found in a study that was done on the correlation between Facebook’s revenue and it’s number of users; and that correlation turned out to be significant. Taking the logic of Metcalfe’s Law into account and the results from studies of Facebook’s revenue seems indeed to confirm that the number of bitcoin’s users/nodes does contribute to its inherent/intrinsic (utility) value. But how can we apply that specifically for a bitcoin’s valuation model?

First of all we would have to define what we use for “n” in the specific case of bitcoin: the number of users or devices or full nodes and/or wallets or wallet addresses? In my opinion in case of bitcoin the number of nodes + wallets would qualify best as the metric for “n”, however this might be hard to determine, because the number of wallets not being full nodes might be hard to identify. A lot of research has been done by many, and best results have been found in correlations between price development and number of addresses (described as either unique or active).

A lot of data research and mathematical calculations are being done on the Metcalfe’s Law principle, but the simplest implementation comes from well known Fundstrat’s analyst Tom Lee, that uses the formula as follows, to calculate the value of bitcoin’s network: n² x the average transaction value. According to Tom Lee this formula correlates well with bitcoin’s price as it explained 94% of bitcoin’s price movement in a past period of 4 years.

The logic of such a formula resonates very well with me personally in terms of assigning some sort of intrinsic value that can be used as valuation compared to the actual price that makes some sort of sense so that we could determine a price direction and over- or undervaluation. Also with this formula it would be possible to make a prediction of the future price of bitcoin based on what an expected status of adoption would become in terms of number of users and how much value they transact on the bitcoin network. Very promising method indeed.

NVT Ratio: Network Value to Transactions Ratio

This valuation method is sort of a variation of and in the same realm of thinking as Tom Lee’s method; and this is the bitcoin network equivalent of the P/E (price/earnings) ratio for stock valuation. In this method the value of Network Value is the marketcap and the value of Transaction is the total value of transactions. We simply divide the total marketcap by the total value of transactions in a certain period (an average can be applied to make the graph smoother).

What the ratio shows is how far the market cap is stretching away from the actual value that is transmitted over the network; it does this by comparing how much bitcoin is valued and by how much it is actually used. If the ratio goes above a certain range of normal, we can assume that the price of bitcoin is “overvalued” and in a danger zone.

According to the inventor of this method, Willy Woo, the NVT ratio is particularly helpful in times of price corrections to identify if the correction is only a consolidation (and will continue its upward trend) or that the correction will accelerate into a real crash. If the NVT ratio is within the normal range, a price correction suggests consolidation, if the NVT ratio is above normal range (= the value of transactions does not justify the value of the market cap), a price correction may suggest a full blown crash.

Also this method seems to make a lot of sense in terms of the logic behind it. In the article he published last year on Forbes, you can definitely see some examples where this ratio applies very well for different types of “bubbles”. https://www.forbes.com/sites/sap/2018/08/02/to-appreciate-the-value-of-digital-networks-look-to-the-skies/#3402ca3d15d5

Sentiment

Not so much a valuation model, but more an indicator, could be ways that we can measure the sentiment of the public about bitcoin in order to predict the near future direction of the price. Simple methods are the results of certain Google searches as “buy bitcoin” or “is bitcoin dead”, this can already give you a small hint of if there is a shift in sentiment. During the last 2017 bubble, the increase in Google searches formed a nice correlation with the increasing price, even so when Google searches dropped along with the price.

Besides Google searches there are also AI algorithms that scroll the internet and social media looking for keywords that may predict a developing sentiment among the public and be able to predict the effect on the price.

One problem with measuring sentiment in my opinion is that it is a very reflexive relationship between price and sentiment. Actually in a way Technical Chart Analysis is also partly based on interpreting the current sentiment of market participants reflected in the development of price patterns and as the sentiments and reactions on sentiments are fairly predictable, TA (Technical Analysis) seems to work quite often (often enough to make it relevant). TA is also reflexive, because the way the price moves, influences investors’ sentiment, which influences their actions in the market, which influences the way the price moves and in this reflexive feedback loop it continues.

This goes as well for the way of measuring sentiments on search engines and (social) media: if the price is not going up, the sentiment is dull, google search does not go up. If the price goes up, more people start talking about it, start searching it, which results in more people getting FOMO and starting to buy, which makes the price go up more, more people talking, more people searching, the price goes up more and so on.

Of course using AI algorithms to make better predictive analysis based on more accurate data is something for experts or those who can afford to buy reputable services. Of course the more people use these, the less effective they get.

BMI: Bitcoin Misery Index

Another measurement that partly relates to sentiment comes again from Fundstrat’s Tom Lee: the Bitcoin Misery Index (BMI). It is a contrarian index based on the principle of “buy when blood is in the streets”, which gives buy signals at maximum “misery” of investors/traders. The index makes a calculation of the percentage of winning vs trades as a factor and volatility as a factor. The index goes from 0 to 100 and below 27 it produces a buy signal because there are investors at their peak of losing trades (and thus and their peak of misery).

Although this indicator has given some fairly good signals in the past, it is unsure how reliable it remains, because market circumstances do change as well as the type of investors that enter the market (more sophisticated investors, means different decision making process); also, like always, such indicators do not account for unknown unknowns like exchange hacks or what not. I would not recommend this metric as a sole decision making model, rather as something to keep an eye on in the overall decision making process. In this Cointelegraph article you can see more of how this indicator works and the accompanying graphic: https://cointelegraph.com/news/wall-street-analyst-creates-bitcoin-misery-index-for-traders

A simple indicator that combines the concepts of the last 2 methods (Sentiment and BMI) is the Crypto FEAR & GREED index, which calculates a combination of factors: volatility, momentum/volume, social media, surveys, dominance and trends (Google trends data).

Calculation methods based on mining costs

Similar to perhaps other assets, the production cost of an asset is a factor of influence on the price it needs to have in order to be an economically viable product. A physical gold miner also needs to receive at least the price of the cost of their mining operations for the gold it sells. This is similar for bitcoin mining: these miners need to sell their bitcoin for their cost of mining and preferably plus profit for them to be able to even continue their operations. A few different methods try to couple the bitcoin price with the cost of mining:

  1. A multiplier on the cost of mining
  2. Net Present Cost (cost of mining vs cost of purchase on an exchange)
  3. Average cost as bottom price for bitcoin

Overall I need to start by saying that any calculations of mining costs need to take a lot of arbitrary assumptions into account, which in my opinion give these methods a lot less merit. The most important factors for the cost of mining are: electricity cost, mining difficulty, cost of mining hardware and the general overhead of mining operations.

Problem is that the cost of electricity is different worldwide, so it is hard to calculate a precise number for this, even though we can assume that most of the mining takes place in China, so the cost of electricity is closer to China’s rate than for example the rate in the US.

Another problem is that there are big differences between individual miners and large mining firms in terms of operating cost, scaling advantages AND available electricity rates.

So to calculate any reliable number for mining cost on a worldwide scale to be able to map it to the price of bitcoin seems mostly useless in my opinion. However if we COULD calculate a reliable number, it would probably have some merit to be able to peg some value to bitcoin that relates to its price. So let’s assume we do have a reliable known cost of mining (or at least an average).

Multiplier on mining cost

First let’s take the multiplier on the cost of mining. This method let’s you calculate a fair value of bitcoin, based on the cost of mining. It simply assumes that a fair value would be 3x the cost of mining, which is a completely random multiplier, but you could make the argument that this could be seen as the maximum reasonable price for a bitcoin should have in relation to its production cost and that if the price goes much higher than that, the price should be considered irrational or overstretched.

Of course the valuation does not only directly depend on mining cost because as we have seen Network Value and the volume of transactions also play an important part of its valuation. But in the valuation model that relies on the cost of mining we can assume that when adoption, users, price and number and value of transactions increases, the required mining power and thus mining cost will also increase, so in that sense there should be a sufficient correlation between the network value and mining cost. Another value proposition for bitcoin is the security of its network, which increases when the required mining power increases and thus the cost of mining increases; also in that sense the cost of mining seems to be correlated to the value of the network’s security.

Net Present Cost

Another method based on mining cost is the Net Present Cost. This is a calculation that takes into account the total cost of mining including the hardware investment and including the cost for the required capital and effort. The method calculates the break-even-point between the investment in a mining or the investment of buying simply bitcoin on an exchange. This should function as an equilibrium that the price of bitcoin should fluctuate towards, meaning that if the price gets higher than the Net Present Cost which means mining is more profitable, which means more people will invest in mining, so the competition (mining difficulty) increases, which will bring the Net Present Cost back closer to the market price. If the price falls below Net Present Cost, it means buying on an exchange is cheaper than mining, thus it is more attractive to buy bitcoin on an exchange than it is to invest in mining, which should theoretically eventually increase investment demand on exchanges (relative to investment in mining), so the price rises back towards Net Present Cost.

Average mining cost as price bottom

Another theory that could influence bitcoin’s price is the so-called and debated average cost of mining that functions as a bottom for the bitcoin price. This is currently (summer 2018) a popular theory since we are in a bear market and currently we have the market seen bouncing at least 3 times around the $6,000 level. What is argued is that this current bottom of $6k is the average cost of mining under which miners are not willing to sell their bitcoin because they would be selling at an operational loss, so they would prefer to hold until they are able to sell at a higher prices for a profit. Because under normal circumstances there would be a constant selling supply of bitcoin from miners that have to pay for their operational expenses, anytime the price drops below that cost of mining level (assumed to be around $6k currently), the miners suddenly stop selling, which everytime reduces the supply by selling pressure which immediately stops the price from falling. Very reasonable theory that makes a lot of sense, but unfortunately without sufficient evidence to back it up. But it is good anyway to keep this possibility in the back of your mind because such a factor may certainly have any kind of influence on the price development of bitcoin.

Logarithmic regression of Bitcoin

Logarithmic regression is a formula that calculates growth that is very rapid initially and slows down over time. Some people in the early years of Bitcoin made a model that was partly based on growth numbers compared to price in a valuation model based on Metcalfe’s Law (that we discussed previously in this article) and resembled the adoption rate/growth of bitcoin based on the growth of users (unique addresses), which is usual for an adoption curve, because the percentage growth in numbers of users tends to flatten after an initial high rate of adoption. They came up with a logarithmic regression formula that resulted in this graphic:

Image from: https://bitcointalk.org/index.php?topic=831547.msg9293359#msg9293359

This model resulted in projected future prices of bitcoin up until a bitcoin price of $1million. These were the important milestone projections from the available data at that time:

1,000 24–04–2015
10,000 22–11–2017
100,000 16–07–2021
1,000,000 06–09–2026

As you can see in the graph up until the time the logarithmic regression was updated the price was swinging nicely in the same trend. If the logarithmic regression of network’s adoption rate stays in tact, the projected date to achieve a bitcoin value of $1,000,000 would be the 6th of September 2026! However after the publication the trend was lagging for a few years and the price was not anywhere near $1,000 at the end of April 2015 due to the extended bear market that bitcoin was in at that time, even though it had already surpassed $1,000 ahead of schedule on the 28th of November 2013 and would not cross the $1,000 mark until Jan 2, 2017. And then something scary happened: on November 28th of 2017 (only 6 days difference from the original projection!!!! AND on the day precisely 4 years after crossing $1,000!!!) bitcoin’s prices indeed passes $10,000! Now is that a scary coincidence or not I ask you?! Even though I am not aware if the chart is recently updated with the latest adoption numbers to see how the regression and projections are positioned currently, but the scary coincidental breaking on the $10,000 mark does make me suspect that we are still on track for a $1,000,000 bitcoin in 2026!

Quantity Theory of Money: MV=PT

There have been speculative theories about people trying to tie the “fair value” of bitcoin to the famous economic formula MV=PT and notoriously they always try to tie bitcoin to the global drugs market in order to make that formula come up with a value for bitcoin. And surprise, surprise, miraculously and seemingly “coincidentally” the value that comes out seems not that far from bitcoin’s price. But is it really a meaningful metric? Let’s take a look!

First the formula explained:

M = Money supply (usually M1, which is “near cash” held for short/medium term expenses)

V = Velocity of money (how many times does a currency unit change hands on average)

P = Price level of goods and services

T = The number of transactions performed for these goods and services

The reasoning for this equation is that the all money in circulation times how many times each unit changes hands should be equal to the total amount of product and service bought and sold times their price level; this is MV = PT and it is an undeniable truth.

Now how does bitcoin fit into this equation? What they argue is that equally as the base value of fiat currency is that it is the required currency to pay taxes with (which therefore gives it its base value), the base value for bitcoin would be is that it would always be useful to buy drugs with. (The latter is not so true, at least not anymore, because it’s open, public ledger makes it a very bad currency to use for illicit activities, so it’s getting used for that less and less) The people arguing in favor of this calculation method then say that in order to derive bitcoin’s fair value we would need to single out the drugs market in the hypothetical situation that all drugs in the world could only be bought and sold with bitcoin and that all other use of bitcoin were outlawed. In this scenario it would be possible to use the equation MV = PT to get bitcoin’s fair value as follows:

First of all a lot of assumptions have to be made:

As Velocity they assume it to be 10, which apparently is a reasonably reliable number for currency velocity. Then the ESTIMATED global drugs market figure from a UN report is used, in the latest case: between $426 billion and $652 billion.

Then, the so-called Purchase Power Parity is used for T, by saying that the BTC/USD rate for products is so tightly entangled (for example: a products price in BTC changes according to how the BTC/USD price changes). Which means that the dollar volume of transactions than can be done in bitcoin can represent T; in the drugs market example: T = 426–652 billion. This means that for $1 I can buy $1 worth of drugs, but I can also buy $1 worth of drugs with $1 worth of bitcoin. In this scenario P can represent the bitcoin value of a dollar.

Furthermore we need to assume the long term value, so we also need to assume the long term supply of bitcoin (which will soon be near 21 million, so we round it off to 21 million). With an assumed velocity of 10, MV = 210 million. So if we want to know P (the bitcoin value of a dollar), knowing that MV = PT, the calculation is: P = T / MV = 426 billion / 210 million = $2,028 OR P = 652 billion / 210 million = $3,104. Because we don’t actually know the precise number of the drugs market, we can can only get to a range of the estimated upper and under limits, so that means, according to this method, the “fair value” of bitcoin should be between $2,028 and $3,104. And this price it has actually been last year, but that of course can only count as circumstantial evidence.

Now what is wrong with this method:

  1. It assumes a constant velocity of 10, while velocity is rarely constant, specifically: M1 (near cash for short/medium term expenses) for USD has been between 5 and 9 in the last 8–9 years. If the velocity changes.
  2. The velocity of “drugs money” might be different than the average velocity of currency. This could alter the outcome.
  3. The choice of velocity assumes bitcoin as if it would be ONLY used purely as currency for short/medium term expenses/means of payment, while we know that bitcoin is and will be ALSO used as a store of value (HODLers), so this way of valuation seems inherently flawed just because of that.
  4. The valuation is entirely based on the fairly random choice of drugs market as base for bitcoin’s value, while bitcoin’s use case would be similar for any other illegal market, like human trafficking, weapons or even the market for ALL illicit trade, for which the assumptions for calculation would work just as well, but the outcome for bitcoin’s fair value entirely different. The total market for all illicit trade would make T = 1.6trillion or 2.2trillion. That would make P = $7,619 or $10,476.

As you can see this calculation method for bitcoin’s fair value has little to no merit. The actual thing that you are calculating by this method is how much bitcoin SHOULD BE worth to be able to function as the only currency for drugs trade.

Now what we COULD calculate by using MV=PT by using similar assumptions, is how much bitcoin SHOULD BE worth in order to replace ALL currency worldwide! For this we would have to include long term savings (M2) for velocity, let’s assume recent velocity for the M2 for USD, V = 1.5; also assuming that HODLer mentality in bitcoin will become more equal to current long term savings levels for global currency, so MV = 21million x 1.5 = 31.5 million. And also we will use the Gross World Product (all trade worldwide) which I am estimating to be around $90 trillion, based on recent numbers plus growth rate till now (2018), so T = 90 trillion. Again, P = T / MV = 90 trillion / 31.5million = $2,857,143!

That means that in order to replace all the world’s currencies and facilitate all trade in the world (as of the numbers in 2018), bitcoin’s value has to become worth roughly $2.9 million! You could use this as the long term absolute upper ceiling of the bitcoin price (although by then there would theoretically not be dollars anymore to express the price in). That upper ceiling grows by the growth of GWP, which is around 3% annually, which means no more moon mission either, because we already landed on the moon a long time ago by then.

As a side note, if bitcoin would primarily be used as a store of value only, we could calculate another sort of ceiling, if we assume the total amount of bitcoin to be ever equal in value to the total value of all gold ever mined on the planet and we use the valuation of gold per 2017 ($7.5 trillion), the value of bitcoin should be 1 BTC = $7.5trillion / 21 million = $357,142!

Conclusion

So now we have explored a great variety of valuation methods for bitcoin of which some seem to have more merit than others, but most of them I do believe have at least some influence on how the price and value of bitcoin is ultimately defined and established. Personally I am a great believer in the principle of Metcalfe’s Law that attributes a certain quantifiable intrinsic value to a network. The precise calculation method of how to most accurately calculate the underlying value of bitcoin (and its network) versus its price will probably require more research, but for now this law has already resulted in some arguably usable metrics and indicators for predictions in terms of (over and under) value and potential price direction.

At least we can also argue against the no-coiners talking point that bitcoin does not have an underlying value, because clearly we have metrics that can prove economic value. Still improvement is needed and the calculation methods need to mature more, which will become easier once we get more data over time (the short history of bitcoin as new asset class simply doesn’t provide us yet with enough data obviously).

However, despite any rational valuation model we can come up with eventually that would accurately quantify the true or fair value of bitcoin, ultimately it is supply-and-demand that determines the price and supply-and-demand is the aggregate decision of all market participants on how much they believe bitcoin is worth, therefore ultimate we can simply read in the most recent price chart how much bitcoin is worth, how irrational it might seem (markets always over react) in the eyes of any rational valuation model. However combining the interpretation of the (most of the time) irrational price of bitcoin and the knowledge of the rational true value of bitcoin, may both enable us in determining the most likely (near) future direction of that price so we can hopefully make more calculated risks and more educated investment decisions.

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