Along with increased awareness in the general population about what Bitcoin is, there has been a rise in interest in the difficult topic of how to value the world’s most popular digital currency.
The jury is out on this controversial problem, but a few valuation methods are gaining more support than others.
Method 1: Comparable analysis
Comparable analysis values Bitcoin by comparing it to similar assets in worldwide markets. Most often, Bitcoin is compared to gold, or US M2 Money Supply (a measure of how much US currency circulates in the economy)
The rationale behind comparing Bitcoin to gold is that Bitcoin can be used as a store of value, and the rationale behind comparing Bitcoin to US M2 Money Supply is that Bitcoin can be used as a medium of exchange.
In July this year, New York University’s finance professor Aswath Damodaran, often referred to as Wall Street’s “Dean of Valuation”, predicted that digital currencies will eventually be as important as the major paper currencies. He also said that digital currencies has already replaced gold for younger investors.
For the sake of example, let’s suppose that we agree with Damodaran’s predictions, and assume that due to younger investors using Bitcoin as a replacement for gold, the market cap of Bitcoin should be at least 2% of the market cap of gold.
Valuing Gold Using Comparable Analysis — Gold
Market Cap of Gold = $7.86T
Market Cap of Bitcoin as a % of Market Cap of Gold = 2.00%
Target Market Cap of Bitcoin (2.00% X $7.86 trillion) = $157.2B
Total Bitcoin Supply = 17M
Value of 1 Bitcoin($157.2B / 17M) = $9,247
Similarly, let’s suppose we believe that if Bitcoin will ever be as important as major paper currencies like Damodaran suggests, then its market cap should be at least 1% of US M2 money supply.
Valuing Gold Using Comparable Analysis — US M2 Money Supply
Total US M2 Money Supply = $13.76T
Market Cap of Bitcoin as a % of US M2 Money Supply = 1.00%
Target Market Cap of Bitcoin (1.00% X $13.76 trillion) = $137.6B
Total Bitcoin Supply = 17M
Value of 1 Bitcoin($137.6B / 17M) = $8,094
The advantage of comparable analysis is that it is relatively simple. The disadvantage is that it is not very rigorous. As you can see, comparable analysis is essentially back-of-the-napkin calculations that rely on assumptions that are difficult to rationalize (such as how big Bitcoin will be relative to gold or US M2 Money supply in the future).
Overall, comparable analysis is an interesting tool to be aware of, but it oversimplifies too many factors to be used in a professional context.
Method 2: Quantity theory of money
The second valuation method attempts to value Bitcoin by applying macroeconomic theory on how currencies can be valued. According to basic macroeconomic theory, the price of a currency can be determined by the following equation:
Value of a Currency = Total Value of Goods Bought Using the Currency in a Year / Total Units of the Currency Spent in a Year
Adjusted to fit the context of Bitcoin, the above formula becomes:
Price of a Bitcoin = Total Value of Goods Bought Using Bitcoin in a Year / Total Units of Bitcoins Spent in a Year
Where:
Total value of goods bought using Bitcoin in a year is the sum of the value of all purchases made using Bitcoin in a year, and;
Total Bitcoin spent in a year refers to the total number of Bitcoin that were transacted in a year.
For the sake of example, let’s suppose that $500B worth of e-commerce products are bought through Bitcoin each year, $1T worth of retail products are bought using Bitcoin each year, and that no other goods are bought using Bitcoin. This would mean that the total value of goods bought using Bitcoin in a year is $1.5T.
On average, according to both coincap.io and coinmarketcap.com, 3% of all Bitcoin change hands each day, and there are 365 days in a year. Multiplying the number of days in a year by the percentage of total Bitcoin that change hands each day implies that the average Bitcoin changes hands approximately 11 times per year (365 days X 3% of Bitcoin change hands each day).
If we multiply the total supply of Bitcoin by the number of times the average Bitcoin changes hands per year, we find that 187M Bitcoin are spent each year (17M Bitcoin X average Bitcoin is spent 11 times per year).
Given this information:
Price of a Bitcoin = Total Value of Goods Bought Using Bitcoin in a Year / Total Units of Bitcoin Spent in a Year
Valuing Bitcoin Using Quantity Theory of Money
Total Bitcoin Expenditure Value in a Year = $1.5T
Total Bitcoin Supply = 17M
Number of Times the Average Bitcoin Changes Hands in a Year = 11
Total Units of Bitcoin Spent in a Year (17M X 11) = 187M
Value of 1 Bitcoin($1.5T / 187M) = $8,021
The advantage of using the quantity theory of money to value Bitcoin as a currency is that this is a method that has been proven to work for valuing currencies in the past. The disadvantage of this method is that total Bitcoin expenditure value in a year can be very difficult to estimate.
Method 3: Bitcoin “P/E ratio”
When we look at stocks, one of the first valuation measures we look at is the Price / Earnings ratio, which is equal to the market capitalization of that company divided by the company’s annual net income.
The P/E ratio cannot be used in the context of Bitcoin, since Bitcoin is not a company with earnings, so analysts have been trying to come up with an analogue valuation measure for Bitcoin.
A key insight is that the P/E ratio compares the price of a company against the company’s utility to shareholders. Many financial analysts believe that Bitcoin’s utility to unitholders is the ability to move money, or transact.
Based on the belief that Bitcoin’s core utility to unitholders is the ability to move money, a proposed analogue for P/E ratio for Bitcoin is a Price / Daily Transaction Volume ratio. This is equal to the the market cap of Bitcoin divided by 24-hour trading volume. Below is a chart that shows the 50-day moving average for Bitcoin’s Price / Daily Transaction Volume ratio since 2014.
Zooming in on 2017:
From the perspective of the Price/Daily Transaction Volume Ratio, Bitcoin’s valuation seems to be decreasing over time. Currently, Bitcoin’s Price/Daily Transaction Volume sits at around 45.
Depending on how you interpret this trend, either Bitcoin was extremely overvalued in the past, or undervalued in the present.
The advantage of using the Price/Daily Transaction Volume Ratio is that it is an easy-to-calculate proxy for measuring the value of Bitcoin as a currency. The disadvantage is that since Bitcoin is still so relatively new, nobody knows what a high or low value for Price/Daily Transaction Volume is or where it will settle.
What valuation method is best?
Different people choose different valuation methods based on what is known, comfortable, or simple to calculate.
Bitcoin enthusiasts, for example, prefer valuation method one (comparable analysis) since it is simple to explain and understand. Economists, on the other hand, prefer valuation method two (quantity theory of money) since it applies mainstream economic theory. Business Analysts conversely prefer valuation method three (Bitcoin “P/E ratio”) since it uses ratio analysis similar to what they would use when valuing businesses.
In reality, no valuation method has been widely accepted or agreed upon as being correct.
Different camps apply different valuation methods according to what makes most sense from their perspective. Ultimately, it is up to each individual investor to decide which valuation method is best themselves.
Note: The goal of this article is to discuss possible methods of valuing Bitcoin. This article may not be exhaustive, and does not endorse any specific valuation for Bitcoin.
Original Article was posted on coinsquare.com @ https://discover.coinsquare.io/digital-currency/exploring-bitcoin-valuation-methods/
