Fundamentally Valuing Bitcoin at $45,000 / BTC

Summary: I will try to distill down monetary theory help you fundamentally understand how currency and Bitcoin is valued.

I claim that: 1) Bitcoin has negligible intrinsic value without mainstream use as a transactional currency, 2) that despite this, Bitcoin can still hold value based on a different valuation model, 3) a valuation of Bitcoin, and 4) how a cryptocurrency like Facebook’s Libra affects Bitcoin’s valuation.

Let’s start with how the US Dollar, gold, and Bitcoin is valued.

How is the USD valued?

Quick answer: MV=PQ.

Long answer: With the USD, the government expands and contracts the money supply. “PQ” is the total value of transactions in the economy. So GDP would be an approximation for “PQ” for one year. “V”, or velocity, has averaged seven historically. A velocity of seven simply means that each dollar is exchanged seven times on average per year.

Velocity of M1 Money Stock; Source: Federal Reserve Bank of St. Louis

With greater supply of money, “PQ” tends to increase. Think of this as more money = more spending. During periods of growth, the government keeps a careful eye on the growth rate, because too much money can lead to higher prices and inflation. At the extreme, a loaf of bread was worth a trolley of cash in WWI Germany because there was so much fiat money printed.

WWI Germany Hyperinflation

In addition, inflation often results in rising wealth for holders of assets like real estate and stocks, while those only holding cash lose the purchasing power of their money. This results in a widening of the wealth gap. Other repercussions of too much money printing include people taking on debt to buy asset, which raise the likelihood of bankruptcy when a plethora of money leads to bad asset purchases at too high of a price.

All this leads to a negative spiral of economic contraction. And that is why the money supply must be carefully monitored and controlled. If this concept doesn’t make sense, see this great explanation by Ray Dalio, manager of the world’s largest hedge fund.

Just remember, the government expands and contracts “M”, the money supply. The Federal Reserve aims for price stability and productivity gains, meaning they hope to increase the money supply in pace with productivity gains.

To intuitively understand MV=PQ, think of it like this. You are a millionaire wanting to buy a $42 million jet with this new currency called Bitcoin. Let’s assume there are 21 million Bitcoins in circulation, and each trade at just $1.00.

That means you literally could not conduct your $42 million purchase with Bitcoin even if you owned every single one, because its market cap would only be $21 million. Bitcoin would have to at least rise to $2.00, or a market cap of $42 million, for you to make this transaction. Thus, the more transactions (“PQ”) occur, the greater the market cap (“M”) of a currency.

We will soon get into how this applies to Bitcoin’s valuation.

How is Gold Valued?

People like to say gold doesn’t have intrinsic value, and that its $7 trillion market cap is primarily a result of its use as a store-of-value. This is not true. Around half the above-ground stock of gold is used jewelry. 17% is held by countries in their reserves. 21% is private investments.

In other words, think of half the world’s gold supply as used for practical purposes such as jewelry, and the other half as investments sitting in a vault. Ultimately, the trading price of gold on an exchange is determined by 1) the demand of gold in jewelry and other use cases like electronics, and 2) the supply of gold available for such use (i.e. the supply not sitting in reserves). Demand and supply, as simple as that.

All this is to say that the total market cap of gold, $7 trillion, is determined by the supply and demand of gold as it is used for economic purposes. If gold did not have economic use, there would be a huge fall in demand, and a resulting fall in price.

In this scenario, the only way gold could serve as a good store of value would be if and only if everyone else decided it was a good place to park money. So it becomes a confidence game. And that would be close to what we call a bubble, because the only reason such an asset would have value is because other people deem it so.

How is Bitcoin Valued?

Many people, even well regarded figures in the crypto world, like to say Bitcoin is a store-of-value (SOV), just like gold. But when you look at it from a fundamental valuation perspective, this is not an apt comparison.

To make the comparison with gold work, Bitcoin would need an economic use case, just like gold. For Bitcoin, that use case would be as a transactional currency. So let’s look at the MV=PQ equation again, which shows how a currency can be valued.

Let’s assume:

• Bitcoin achieves a velocity of seven
• 10 million of its 21 million coin supply is freely traded for economic transactions
• Total value of transactions (“PQ”) is $700 billion

V = 7, PQ = 700B and we are solving for M.

M per freely-traded Bitcoin = $700B (PQ) / 7 (V) / 10 million = $10,000

Bitcoin market cap = $10,000 per Bitcoin * 21 million Bitcoins= $210 billion. Our assumptions plugged in result in a price not too far off from today’s Bitcoin market cap. Of course, this also shows that 1) the more transactions that occur with Bitcoin and 2) the lower the freely traded supply, the greater the value of each Bitcoin.

In other words, Bitcoin must be used as an everyday transactions for it to have intrinsic value as a currency.

Ray Dalio reached this exact same conclusion here. He does not discount that Bitcoin may eventually have value, but recognizes that such value accrues to it only when it is transacted as a currency.

In addition, gold is a big part of his asset allocation strategy at his hedge fund Bridgwater, but he does make the faulty comparison of gold to Bitcoin.

If you are a Bitcoin proponent, don’t stop reading yet. The above is not to say Bitcoin’s value should be zero absent transactions. Bitcoin can in fact still serve as a store-of-value, just not by the same principles as gold. I will explain this further down.

Intrinsic Value

At this point, it is necessary to clarify what is meant by intrinsic value.

If you knew everything about the future of a company for the next 100 years — its revenue, margins, cash flows, interest rates etc — you would be able to arrive at a perfect valuation. Let’s say you had a magic ball that told you Starbucks Corporation would continue to produce its current cash flow rate in perpetuity.

If Starbucks Corporation’s stock fell to $0.50 a share, you would confidently scoop up its shares with the knowledge that the cash flow it produces makes it an excellent buy. It doesn’t matter if every other person on Earth thinks it’s a horrible stock.

Photo by Jasmin Schuler on Unsplash

The same with real estate. If prime real estate in San Francisco fell to 10% of what it is worth now, (and let’s say you had a magic ball that shows SF would be a desirable place in perpetuity) it doesn’t matter what anyone else thinks. You would know that investing in San Francisco real estate is a bargain due to the cash flow it can produce.

Likewise for gold — it has real economic demand from producers of jewelry who sell it to consumers for cash flow.

And so it goes for bonds, currencies, future, derivatives, etc.

Does FIAT have Intrinsic Value?

Some astute readers may ask, how does fiat have any intrinsic value? That is a great question. Fiat is unique in this respect from every other asset class — it has no “intrinsic value.”

Background

The US dollar was tied to gold, until they were uncoupled in 1971. This uncoupling allowed the U.S. government to print more money when necessary to “artificially” stimulate the U.S. economy and boost real productivity. A good government at the helm who knows how to properly manage the supply of money could manage real productivity in a way that couldn’t be done before.

But it is a double edged sword because if the government doesn’t manage this well, fiat can lose value very quickly. In fact, there are signs of mismanagement with rising U.S. debt levels today. Not to keep referring to Ray Dalio, but he predicts a non-zero chance of the USD losing its reserve currency status given the current state of affairs.

But back to the main point — fiat technically has no inherent value. Its value comes from the fact everyone accept it as a unit of exchange, after which point we can value it through MV=PQ. What is interesting is that beanie babies or tulips could be used for the exact same purpose if everyone decided that’s what they wanted to transact with. Of course, both of those were well-known bubbles that crashed to zero.

Dutch Tulip Mania

Today, Bitcoin seems no different. But that’s not to say fiat is better. Fiat USD is not that different from tulips, beanie babies, or Bitcoin if not for the sole fact that it achieved acceptance as the way to transact.

At this point, Bitcoiners may proclaim that it is a better form of money than fiat — self-sovereign, permissionless, and censorship-resistant. That is a fair point.

So if you’ve been following along and believe that 1) the comparison to gold as a SOV is not the most apt for Bitcoin, 2) Bitcoin’s properties along with its portability and fungibility make it a better form of currency than beanie babies, tulips, or even fiat, then the natural next question to ask is…

Why not transact with Bitcoin?

After all, Bitcoin seems to have better properties than fiat and the only thing it needs to beat fiat is to be accepted in transactions, after which we can assign it a real intrinsic value through MV=PQ.

Unfortunately, that is unlikely to happen. Bitcoin transactions are too slow to compete with Visa and the current centralized infrastructure. The tepid adoption rate of Bitcoin in the past ten years for use in transactions has shown this.

What if Bitcoin infrastructure improves and becomes a major form of payment?

Again, unlikely. Mike Hearn, a very highly respected developer and one of the first people to work with Satoshi Nakamoto on Bitcoin, explains why here.

“ But despite knowing that Bitcoin could fail all along, the now inescapable conclusion that it has failed still saddens me greatly.” — Mike Hearn, original Bitcoin developer

Satoshi had hoped that Bitcoin could achieve Visa-level scale as seen in this email transcript, but also recognized that it was just an experiment. Bitcoin has failed in that particular use case.

The Fundamental Investor’s Conclusion

Hopefully now, you get the sense that Bitcoin’s value depends on it achieving widespread use in transactions, in a fundamental valuation sense. If you are a fundamentally driven value investor, the question to ask yourself is: Do you believe you can reasonably predict the chance of a fiat apocalypse, and what market share Bitcoin will take in such scenario?

Many of the most successful investors in history have spoken against holding Bitcoin. Among this list include the well-known macro investors George Soros and Stanley Druckenmiller who “broke the Bank of England” betting against the British pound (and earning themselves billions in the process). These are experts in currency, so it makes sense to listen to what they think.

“You keep telling me it’s [Bitcoin] going to be a store of value like gold. Maybe, I mean it could go to a million. But I don’t understand why it’s a store of value, other than you can’t create it. Well there are a lot of things you can’t create that aren’t going to go to a million” — Stanley Druckenmiller at The Economic Club of New York, 2019

From an intrinsic valuation point of view, there is no margin of safety in Bitcoin. This means Bitcoin can theoretically fall back to a couple cents a coin, and you would have no ifs or buts to say. You knew it all along.

Of course, just because intrinsic value is zero does not mean that is how it will trade in practice. In fact —

Bitcoin can still Serve as a Store-of-Value

There is one asset class we have not spoken about, whose price is supported by nothing other than what the next person is willing to pay for it — fine art.

Guernica by Pablo Picasso

A Picasso painting is a bubble in the sense that its multimillion dollar price tag is based on nothing other than what someone is willing to pay for it. Let’s say you paid $100 million for a Picasso piece, hoping it would serve as a good investment. The next day, news hits that Picasso’s hidden journal has evidence he was a very bad person.

Let’s also assume that this causes the every single person in the world to lose interest in Picasso’s paintings, and the most someone is willing to pay for one now is $10. If the same thing happened with Starbucks stock, you would be scooping it up with joy. With Picasso, what other people deem as its value becomes its value. Not too different from beanie babies, tulips, or Bitcoin.

However, there is one major difference. This Picasso bubble is an impenetrable steel bubble that can’t be popped. This is because we know that realistically, Picasso would almost never fall to $10 a piece, as Picasso’s art is 1) considered one of the best, 2) of historical significance. And the more time that passes with Picasso’s art remaining valuable, the more reinforced this concept gets.

Bitcoin is similar. Everyone knows that Bitcoin is the father of cryptocurrency. It is considered the best; a cryptocurrency of historical significance with only 21 million in circulation. And the more time that passes with Bitcoin staying dominant, the more reinforced this concept gets.

And so, Bitcoin is like a Picasso masterpiece. Just as we know Picasso art would never fall to $10, we can be fairly certain Bitcoin won’t fall to $10 anymore given its mindshare and global prominence. We can value it as:

Bitcoin market cap = % of assets people want to store in crypto * Bitcoin’s % of crypto market share

In fact, you could arrive at a rough valuation for Picasso’s art pieces the same way:

Value of Picasso’s art pieces = % of assets rich art enthusiasts want to store in fine art * Picasso’s % of fine art market share

Valuing BTC

Using the equation above, let’s make a conservative estimate.

Let’s assume:

• The world wants to put 1% of their assets in Bitcoin
• Bitcoin keeps 30% of crypto market share (it is ~50% historically)

U.S. household net worth in 2018 was approximately $100 trillion.

Bitcoin’s market cap = $100 trillion * 1% * 30% = $300 billion = $14,285 / BTC

Bitcoin’s is currently at $11,000 / BTC as of June 2019.

Of course, the above assumptions are extremely conservative in several ways.

1. I only included U.S household net worth, and not that of businesses and the government, which would boost U.S. net worth by another ~50%.
2. Bitcoin is a global phenomenon, not just the U.S.
3. Bitcoin’s market share has consistently stayed above 30% for all of crypto’s history, despite the emergence of competitor cryptocurrencies that transact faster like Bitcoin Cash.

Credit Suisse Global Wealth Report, 2018

Assuming $317T for global household net worth (source: Credit Suisse Wealth Report, 2018), a 50% market share for Bitcoin, and 1% of global assets in Bitcoin:

Bitcoin’s market cap = $317 T * 1% * 50% = $1.58 T = $75,238 / BTC

This results in a 30% to 700% upside from today’s prices depending on your input assumptions, and a midpoint of $45K / BTC.

All this is bullish for Bitcoin as an investment, provided you believe that Bitcoin is a steel bubble. And a steel bubble means it’s not really a “bubble” at all, just as you wouldn’t call a Picasso a bubble. It is a real store-of-value.

There will always be people willing to hold some of their net worth in an asset where no government can reach, just as there will always be people willing to pay up for rare art. That by itself gives it value. So “steel bubble” is a misnomer in that it isn’t a bubble in the traditional sense. But let’s continue using this term for convenience.

Libra

What does Facebook’s recent announcement of their Libra cryptocurrency imply for Bitcoin’s valuation? Libra can be a good or bad thing for Bitcoin, depending on how you value Bitcoin. Let’s put transactional-use proponents in Camp 1 and steel bubble proponents in Camp 2.

If you are in Camp 1, Facebook’s Libra coin is bad news as a Bitcoin investor. For you, Bitcoin’s valuation is determined from expectations of future transactions, which happens when it takes market share away from fiat. The best market to achieve this is in emerging countries where people distrust their government’s fiat. This just got harder with Libra because it

1. is stable
2. aimed at the 1.7 billion people without access to banking services
3. has the goal of achieving widespread use in transactions

If Libra is used as a currency, that is directly taking from Bitcoin’s market opportunity. If not Libra, it may be another stablecoin.

(Zuckerberg screws the Winklevii once again)

If you believe however, as I do, that Bitcoin is an impenetrable steel bubble akin to Picasso art (Camp 2), Libra is great news.

Widespread use of Libra in emerging countries will boost crypto’s prominence, and only spur Bitcoin’s adoption.

Conclusion

1. I believe that to invest in Bitcoin is to make a hedge against the chance of fiat’s apocalypse. It will have a place among asset classes as a financial hedge, similar to gold (gold was more or less stable during 2008 while U.S. stocks fell 40%). Of course, I believe that the actual mechanism by which gold is valued is quite different from Bitcoin, as explained above.
2. I can state fairly confidently that BTC will continue to be volatile due to shifting expectations of how and when fiat will collapse. And volatility will make it hard to use as a unit of exchange.
3. BTC will not achieve mainstream transactional use. This is true ever more with the introduction of Facebook’s Libra coin, which will steal Bitcoin’s opportunity in emerging markets. It is a stable, transactional cryptocurrency backed by a basket of fiat currencies.

But that is ok for Bitcoin, if you believe as I do that the “steel bubble” framework is the mental model to value Bitcoin with.

And now you see why so many prominent investors take a strong stance on both sides of the Bitcoin debate. We have Warren Buffett, Ray Dalio, and Stanley Druckenmiller on one side (the first calling it rat poison squared), and Tim Draper, Marc Andreessen, and Michael Novogratz on the other.

“Stay away from it (bitcoin). It’s a mirage, basically… The idea that it has some huge intrinsic value is a joke in my view.” — Warren Buffett

“The historical track record of old white men crapping on new technology they don’t understand is at, I think, 100%.” — Marc Andreessen

So given the premise that Bitcoin won’t achieve *mainstream* transactional use, both groups are right about Bitcoin. The Bitcoin supporters are able to take their stance because they trust that there will always be people who value the self-sovereign, permissionless nature of Bitcoin and will pay up to own it. This exact concept is what the first group of investors would call a bubble, because it is unlike other asset class, such as gold or USD, for which you can calculate an intrinsic value. The debate comes down to how you value crypto’s significance and Bitcoin’s rarity. Like Picasso art.

So should you own Bitcoin?

My recommendation? Hold 1% of your assets in Bitcoin, and nothing more than you can afford to lose due to volatility. I personally don’t follow my own advice, but that’s for another time.

Finally, if you’d like to see a more bullish case for Bitcoin, I highly recommend crypto fund manager Kyle Samani’s post where he makes a great argument for a $100 trillion addressable crypto market. By comparison, my bull case above suggested a $3.17 T addressable market, of which Bitcoin takes 50%. I hope that Kyle is right.

I’d like to thank Carlos Xu for his help in debating and forming many of the ideas in this post.

Additional thanks to Tim Draper of Draper Associates, Haseeb Qureshi of Metastable Capital, and Kyle Samani of Multicoin Capital for kindly offering to read drafts and providing different viewpoints. They have suggested a more bullish stance to my tempered view, and I highly suggest checking them out for those interested in delving further.

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