How to value Bitcoins?

Bitcoin is the original and the most popular cryptocurrency that started circulating in 2009. With all the hype, it has attracted many people around the world. People have their own opinions about this digital currency. Some believe it will change the world, whereas some think it’s just another fad and will fade away eventually. The critical question here is if you want to include this in your portfolio is , how do you value it?

Bitcoin is a remarkable cryptographic achievement, and the ability to create something that is not duplicable in the digital world has enormous value.

— Eric Schmidt (Google CEO, 2001–2011)

Bitcoin has some of the attributes of gold, as some of it has already been mined and some portion is yet to be mined. It has a known finite supply of 21 million. A cryptocurrency like bitcoin is a digital asset, and very different from traditional securities. It can be viewed as a fundamental shift in the way securities are structured, priced and capital is formed and distributed. The way to value this entire crypto spectrum is to take a look on a discrete basis at its different applications and see the amount of market share it will eventually gain. On a broad basis, the more participation there is, the more the amount of economic activity, and subsequently the higher is the valuation of the entire universe of crypto.

Market analysis of cryptocurrencies

1. The S-Curve Analysis:

The s-curve predicts the adoption path of new technology. Bitcoin was first released in 2009, and by 2019, only 10% of American households owned Bitcoin. In 2021, around 25% of US households own it, indicating that it is undervalued. According to the s-curve, it is believed that Bitcoin is still in the early majority phase as measured by the total number of global investors and the total amount invested so far. It is projected that 90 percent of households will own cryptocurrencies by 2029, and only then will they be appropriately valued.

Bitcoin Adoption S-Curve

2. Trend Analysis:

Plotting a regression line to the logarithmic of the bitcoin prices from 2010 to 2020 is able to capture 90% of the correlation. This line indicates that Bitcoin can be valued between $10 million — $100 million in the coming decade. Bitcoin saw a drop in prices in December ’17 because the CME allowed the shorting option on cryptocurrencies and due to the negative branding by various agencies. However, it caught up in its price again in 2020.

Relative Valuation using currency markets

Some people argue that you cannot value a currency, you can only price it and so it becomes a bit contentious. Bitcoin is a digital currency and currencies, in general, have three kinds of values.

• They act as a scorecard
• They act as a transactional reference
• They act as a store of value

So far Bitcoin has only been able to be a store of value, it’s still fairly difficult to use it for transactions. So to value Bitcoin comparable situation in the currency markets can be used. Taking 2017 as a reference, the market capitalization of Bitcoin was $120 billion. So comparable kinds of currencies like 100 dollar bills which are based on supply and demand can be looked at for valuation. The supply comes from the Federal Reserve and the demand comes from the people who would like to have that currency in their portfolio. There were over 2 trillion dollars of hundred dollar bills in the world. Six hundred billion dollars of euro bills can also be added to this figure. So just adding these two figures which are similar assets to Bitcoin, in terms of what they are used for, we end up with a market with just these two currencies of 2.5 trillion dollars. And against that, we have a bitcoin market cap of $120 billion and a total global crypto cap of twice this figure i.e. $240 billion. So just looking at the two major currencies, bitcoin is roughly 9.6% of it. So it’s basically cheap (as per 2017) with high upside potential and can be looked at as high risk and high reward investment.

The Network Valuation Approach

There are several ways to value equity-like simple valuation with respect to the underlying or a relative valuation with the comparable securities. However, it is very challenging for cryptocurrencies because blockchain is structured differently than other traditional technology protocols.
The proof of work is embedded with bitcoin and currently, with other tokens as well. Thus, the payment is made to those who are doing the proof of work, making the protocol layer or the blockchain generate internal cash flow. So it’s different than looking at technologies where applications are laid on top of that. So the most straightforward way we can think to value cryptocurrencies is to think of this blockchain platform as an alternative medium and look at Bitcoin as an alternative digital currency and a share of the total currency market. Bitcoins and other cryptocurrencies are trying to become transaction platforms, meaning that the network’s value will be proportionate to the number of users. According to George Gilder, the value of a network is the square of the number of users. Using this approach, one way to value a Bitcoin would be to take the number of unique addresses, square it, take its product with the transactions executed with each address, and finally take a logarithm of the value. It is observed that this approach was able to explain 94% of the bitcoins moves since 2013.

Factors that affect Bitcoin-prices

These are some of the factors that determine Bitcoin prices that can be incorporated into the valuation models.

• Supply:

Bitcoin had a fixed supply of 21 million since its inception. The cryptocurrency’s protocol only allows new bitcoins to be created at a fixed rate, and that rate is designed to slow down over time. Thus, the supply of Bitcoin slowed from 6.9% in 2016 to 4.4% in 2017 and 4% in 2018. This makes Bitcoin a deflationary currency due to its limited supply. The bitcoin halving event occurs every four years, which corresponds to a significant price increase due to a reduction in supply.

• Demand:

Bitcoin is attracting the attention of retail investors due to increased media coverage, social and developer activities and is increasingly getting popular in countries with high inflation and devalued currencies. The shrinkage in supply coupled with a surge in demand is acting as fuel for Bitcoin prices.

• Mining Cost:

The Bitcoin network requires miners in order to operate. These miners require energy and high-powered computers. This mining process incurs costly electricity bills that, according to some estimates, account for between 90 to 95 percent of overall costs. According to estimates by some sites, electricity consumption for the bitcoin mining process is comparable to the electricity consumption of an entire country.

• Macroeconomic events:

As Bitcoin is globalized and decentralized in nature, it is impacted by the macroeconomic events of nearly every country in the world. Demand for the currency fluctuates as macroeconomic events affect Bitcoin’s ability to add value.

• Regulatory Developments:

The crypto market is mostly unregulated and has garnered a reputation for its border and regulation-free ecosystem. Its regulation status has its benefits and drawbacks. On the one hand, the absence of regulation means that it can be used freely across borders and that it is not subject to the same government-imposed controls as other currencies. But it also means that Bitcoin use and trade can invite criminal consequences in most financial jurisdictions.

Long Term outlook of Bitcoins

Bitcoin is at the very early stage of its adoption. The number of people who own it is quite small and it can be seen as an opportunity. Classical chartists call it a parabolic advanced which means it is accelerating at an accelerating rate. There is a predictable supply rate of Bitcoins that halves every four years, and since the demand is increasing above this rate, the price of Bitcoin is expected to increase.