Abhishek Kothari

Vice President, Sales Strategy & Business Development | US Retail Bank & Mortgage at Citi

How To Value an Idea Called ‘Bitcoin’?

Inside the Debate on Cryptocurrency Pricing & Asset Bubbles

Sebastian Gabriel | unsplash

At the end of this article, you will have some handy frameworks to begin to understand the value and price of Cryptocurrencies. This article is for educational purposes only and should be construed as investment advice or anything else.

“As the value goes up, heads start to swivel and skeptics begin to soften. Starting a new currency is easy, anyone can do it. The trick is getting people to accept it, because it is their use that gives the “money” value.” — Adam B. Levine

A Wet World Backdrop

(A wet world, in this article refers to the physical world while a dry world is the digital world. These terms are commonly used in the tech community)

Today, in one of the largest Merger & Acquisition deal that corporate America has witnessed in a long time, Amazon announced its acquisition of the grocery chain called ‘Whole Foods’ for $13.7 billion which puts the price paid per share of Whole Foods at $42 a share which represents a 27 percent premium on Whole Foods closing price on Thursday.

It is somewhat surprising that an online behemoth chose to invest in the very type of business it disrupted-brick and mortar. But, there is a very good reason for the acquisition. Online and subsequent home delivery of groceries has always been a tough nut to crack. Whole Foods chain of 460 stores across the US and Canada offers a very good compliment to delivery of grocery ordered online through Amazon. For Whole Foods, it provides a respite from activist investors.

The reason I chose this example as an analog to Bitcoin is because it provides a simple framework to begin to discuss the value of Bitcoin.

Establishing the Basics

Consider the example of the Whole Foods acquisition. We know that the total addressable market in the US for groceries is approximately $700-$800 billion. In other words, the market is huge. In a recent report by the Food Institute and AC Nielsen estimates online grocery shopping to grow at a compound annual growth rate between 9–20% which implies a growth in online groceries from 4.3% to roughly 20%(optimistically) which puts online sales at $100 billion. In other words, there is strong growth in the online grocery space.

The important thing to note is that online grocery shopping will reshape but not completely replace brick and mortar stores. Very similar to a belief that Bitcoin will disrupt but not displace fiat currencies/legal tender. Imagine a world where Bitcoin and its ilk-Ether, zCash, Monero and other Cryptocurrencies are traded on F/X bourses as virtual currencies.

In case of the Whole Foods deal, therefore, we know the size of the market, the growth rate, the outcome to some extent, sales and cash flow of the Whole Foods chain and by token of Amazons valuation, an approximate discounted cash flow value per share of $42 and the total. valuation of the firm at $13.7 billion.

The variables for estimating the value of Whole Foods are relatively easy to understand unlike Cryptocurrencies such as Bitcoin, Litecoin and Ether. This is where the heart of the debate lies. Economists could classify these currencies as a store of value and a medium of exchange. Lawyers can actually call it legal tender in some countries such as Japan.

But, Ether is neither. It is closer to an equity share(minus the voting rights) of the Ethereum smart contract platform. For simplicity sake, you are buying an equity share (that an Ethereum miner say Harrison has mined using his computer) on an exchange such as GDAX or a mobile wallet such as Coinbase. It may not pay you dividends but it will pay you in growth of the price of Ether.

The Dry World Analog: Bitcoin

To be simplistic, let us separate Bitcoin and Ether which are a Cryptocurrency and token from the underlying technology- the Blockchain. For argument sake, let’s think about the Bitcoin Blockchain as an operating system and the Ethereum Blockchain as a different operating system just like the MacOS and Windows except that both blockchains are closer to Linux which is open source and free.

Bitcoin is an application (Cryptocurrency) built on the Blockchain operating system while Ethereum is an operating system supporting a myriad of distributed applications (dApps for short) using smart contracts.

Value of Bitcoin

To understand the price of a single Bitcoin, you will need to use models and use your own assumptions on which markets you think Bitcoin will disrupt and why? Once you have identified the markets likely to be disrupted by Bitcoin, you can then assume the percentage of the overall market that Bitcoin will disrupt. Just like in case of Amazon buying Whole Foods, the total grocery market was $700–800 billion with online groceries roughly at $100 billion.

For instance, try using the Bitcoin price speculator model, if you assume that Bitcoin will capture a 10% share of the world gold market, 13.5% of e-commerce market , 10% of global money supply , 7% of the black market and 1/3 of remittance market, that would yield the price per Bitcoin at $40,540 with total Bitcoin mined at 21 million. It would put the total market capitalization at $1.6 trillion. This number excludes losses due to hacking, regulatory pressures and other issues.

wbn - Bitcoin Price Speculator Model - Alpha Version

This is a useful framework to begin analyzing the worth of a single Bitcoin. Again, no models can be foolproof especially with a new technology like Bitcoin.

Valuation of Ether

Ethereum is an operating system of sorts which has already spawned myriad applications such as Gnosis , Augur, Aragon etc. Therefore, the value of Ether has to be tackled in an article of its own. However, I will leave you with one thought: with the introduction of the ERC-20 standard for tokens, Ethers value is all about adoption of Ethereum ie Number of users embracing the platform and the associated network effects.

The Venture Capital Analogy

For another valuation model for Bitcoin, consider the following model proposed by Ryan Selkis in Investopedia. Although, based on various assumptions, price of Bitcoin can have a wide range of values (eg $70,$ 455) per Bitcoin. However, Ryan provides a good foundation to begin thinking about valuation:

The Easy Way To Measure Bitcoin's Fair Market Value: A Do-It-Yourself Guide

If you are a venture capitalist, this is not early stage considering a user base of approximately 12–13 million, the related network effects and the fact that some countries recognize Bitcoin as currency. It could be at a Seed stage with millions of users (including speculators) pouring insane amounts of money in Bitcoin. It is therefore a question of risk appetite.

I’m a recent article in the Harvard Business Review Bong Koh who launched kohfounders — an early stage VC firm has this to say about early stage or angel investments:

You have to take an educated guess about whether there’s a market, and you have to evaluate the other aspects of the pitch. A lot of it comes down to ‘Do you believe in this team?’

In the context of Bitcoin and Ethereum, do you believe in the developer community spearheading the advancement of both platforms.

M Zaveri (a partner at KPCB) also prefers to filter out the noise or bubbles that form around the zeitgeist of the moment. It could be that hot money is chasing the new flavor of the period.

Far Reaching Implications

Dubai has embraced Blockchain as a key part of its strategy to become the happiest city on earth. It estimates that Blockchain will save 5.5 billion Dirham annually on document processing alone. For details on Dubai’s Blockchain strategy, refer:

Smart Dubai

If Blockchain could hypothetically replace the Internet, it’s applications and worth will be limitless. Identifying the right applications that can harness the power of Blockchain with the blessings of the regulators is key to a brighter investment strategy.

What is an Asset Bubble?

An economic bubble or asset bubble (sometimes also referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania, or a balloon) is trade in an asset at a price or price range that strongly exceeds the asset’s intrinsic value (source:wiki)

George Soros on Bubbles

(Source: Business Insider)

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend.

When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia.

As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.”

The chart below is an example of asymmetric bubbles.

George Soros also adds:

In the active or manipulative function market, prices find ways of influencing the fundamentals.

If you chart out Bitcoins price from almost zero in 2009 to $2467 in 2017, this is what it looks like:

Superimposing this chart onto Soros’ chart above, some could argue Bitcoin price is a bubble (considering the insrinic value to be between $7 to $500) while some would argue that the intrinsic value of Bitcoin is much more. There is undoubtedly speculation at play.

Again, this is the early stages of a promising new technology and my guess is as good as anybody else’s.

The Final Chapter

We are far from the final chapter if and when Blockchain attains Internet status. However, always be on the lookout for useful frameworks to guide your thinking. We are at the cusp of an extraordinary revolution and I am sure you wouldn’t want to miss learning about it as it unfolds.

It is almost impossible to put a value on an idea the size of the Internet such as Blockchain. For people willing to invest or speculate in Bitcoin or Ether, that’s another play altogether. Today, the Blockchain is an ‘idea’ (with well understood use cases) and not an globally established and accepted platform. People will have millions of opinions around this idea. Finally, it boils down to what your gut tells you about the acceptance of this idea.

Between a zero symbolized by an anonymous creator of the Blockchain — Satoshi Nakamoto and and the one represented by the eponymous creator of Ethereum — Vitalik Buterin, lies a large quanta of possibilities. Don’t say “surely you must be joking, Mr Kothari?” because I am not.

Of course, at the end, you have to ask yourself this question: is Blockchain an idea whose time has come?

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