How to Value Bitcoin

Bitcoinstacks

By: R. Scott Raynovich

The market has spoken on Bitcoin, as this week it passed the famous threshold of $10,000. Will the Bitcoin valuation be higher or lower than that in five years? Great question. Let's try to answer this. The best way to answer that question is to first observe the context, drivers, and risks of Bitcoin and cryptocurrency valuation. 

Cryptocurrencies are essentially binary events -- they either take over a larger share of the financial system or they do not -- that's it. The skeptics believe they are essentially useless and will fail. The supporters believe it's a revolution. The established financial system is currently very afraid of them succeeding. Is this a reason to expect that cryptocurrencies will fail -- as many Wall St. pundits are predicting? After all, established systems such as bookstores and shoe companies were very skeptical of this thing called the Internet. 

Wall Street's inability to even grasp how to value Bitcoin and other cryptocurrencies is emblematic of this skepticism. This is because cryptocurrencies are new asset classes, making them very difficult to value. It's like evaluating Amazon (AMZN) in 1999 -- or even 2002 -- as if it's just another bookstore. Turns out that those market values for Amazon were low, because the context was much larger than a bookstore. 

Bitcoin valuation as a new asset class

Yet many Wall Street analysts are taking the path of trying to value Bitcoin as if it were a stock. This is a huge mistake. Rather than comparing Bitcoin to Morgan Stanley stock or analyzing whether it's a bubble, why not analyze it for for what it is: an entirely new financial system and asset class competing for market share of the largest market in the world, the global currency and financial system.

Cryptocurrencies are currencies and technology platforms wrapped up in one. They are not stocks. They will not be valued on a P/E basis, but on a market-share basis. For reference, when Bitcoin crossed the $100 billion market cap market a few weeks ago, it was still just a fraction of the $8 trillion global market for currencies. 

Why are Wall Street analysts comparing Bitcoin to stock prices? Bitcoin is not Pepsi. It doesn't sell things. Unlike a corporation, it's unregulated and fully distributed. There is no Bitcoin board and no central point of control. It's an entirely new asset class! This is why it's so hard to value. It's also why some people in New York and Washington D.C. hate it. It's also the same reasons most people love it!

Thomas Lee, Managing Partner and Head of Research at Fundstrat Global Advisor, is an analyst that has great work on the Bitcoin valuation. He sees the valuation metric as being a share of asset classes. He sees Bitcoin reaching $25,000 or higher. He explains this valuation based on a global allocation of 5% of assets to alternative currencies -- kind of the way gold is valued. This makes a lot of sense. 

So far, Lee has been very right. When Bitcoin was much lower -- below $3,000 -- he expected it to reach $6,000 by mid-year. It has exceeded that target, this week crossing the magical threshold of $10,000. 

Seeing Bitcoin and other cryptocurrencies reaching 5% of asset classes is not really a reach, given its market penetration so far. The market penetration is a real, measurable thing that serves as an input into the valuation.

The market is a weighing machine

One of the investing greats, Benjamin Graham, famously said that in the short run the market is a voting machine and in the long run it's a weighing machine. 

Everybody is voting for Bitcoin and cryptocurrencies right now, but what happens in the long run? Bitcoin's value in the long run will be based on its weight -- its market share -- and whether it grows or contracts as an asset class. Is it a good alternative to paper money? Or gold? Or the Fed? 

I don't think the cryptocurrency wave can be stopped now, it's too big. There will be wild swings, for sure. But many of the cryptocurrencies will go much higher as they continue to gain market share. Think of what happens if and when forward-thinking institutions, such as Amazon and other Internet companies such as PayPal (PYPL), start to integrate cryptocurrencies into the system. This will happen before U.S. Congress or the Federal Reserve figures out which actions to take, because technology always moves faster than the regulators. This kind of momentum will force slow-moving regulators to accept them, once they have already been integrated into the system. 

Drivers and risks of cryptocurrencies

Rather than engaging in a mindless debate about whether it's a bubble or not, or whether Bitcoin should be worth more than Pepsi, let's instead evaluate scenarios that make Bitcoin and other currencies go up or down. 

Cryptocurrencies drivers

  • Wider adoption -- such as an uptake by Chicago Mercantile Exchange (CME), which has already been announced, or other large systems such as Amazon.com (which hasn't happened yet) 
  • Further innovation in financial transactions and accounting platforms for cryptocurrencies (blockchain)
  • Growing visibility (press and "my neighbor has it" exposure)

Cryptocurrency risks

  • Regulation -- an attempt to outlaw them
  • Technological failures of major exchanges or platforms 
  • Publicized frauds or market abuse 

Looking at this list, it's possible that many or all of these things will happen, because many of them have already happened, which could drive immense volatility into the cryptocurrencies. We're going to hear more about fraud, there's going to be another major failure, and some people will have their Bitcoin stolen.

But Bitcoin and other cryptocurrencies have already had some of these risks happen and have recovered, proving resilience in the system which builds interest and value over time. For example, the Mt Gox exchange failed and lost millions of cryptocurrencies in 2014. The Chinese government banned cryptocurrency exchanges, yet the values bounced right back. New York state has outlawed exchanges. Bitcoin is like the financial cockroach that nobody has succeeded in killing

The broader context is that the market share for cryptocurrencies is clearly growing -- by real demand. The money flow does not lie. Isn't that the market speaking? If you look at cryptocurrencies as the "Internet of currencies," the 80/20 rule is popular. I see no reason why cryptocurrencies would not reach $1 trillion in market cap, with, say, the top five currencies occupying 80% of that. Let's say that Bitcoin, as the leader, grabs 80% of the 80% (.8 X .8 X $1 trillion). That gives Bitcoin a $600 billion market cap. Recently trading at $180 billion, that gives Bitcoin room to run. Thomas Lee says $25,000. I say $50,000. 

Or maybe one believes in a futuristic sci-fi world -- where cryptocurrencies end up dominating the entire currency market -- kind of like how the Internet has evolved. In that case you could see cryptocurrencies with multi-trillion dollar market caps. 

Why not? In a world where Amazon goes from nothing to the global leader in e-commerce in two decades, this is not an absurd vision. It's possible. 

If you are thinking of making a bet on cryptocurrencies, evaluate the risks, and the potential reward in this context, then place your chips -- or tokens. Or just watch. It's going to be fun. 

(Disclosure: The author has owned a cryptocurrency position, including Bitcoin and Ethereum, since the first quarter of 2017. He does not plan to sell anytime soon.)