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Valuing Bitcoin and Diagnosing Its Unprecedented Volatility
Bitcoin's price is volatile because the collective doesn't yet know how to value it. And "digital gold" is a stale narrative.
Sustaining a market value of about $1 trillion for almost a year, the conversation about bitcoin’s valuation has finally advanced past the skeptical phase. Bitcoin’s unparalleled global brand recognition espouses a network effect that is palpably altering our digital economy. My small business in publishing is just a microcosm of this; I have instantly transacted BTC via Lightning Network (LN) with people from every continent over the past few months as if bitcoin and LN were already the global monetary standard.
Participants are freed from foreign exchange transactions, delay, bureaucracy, and credit card companies as bitcoin becomes the internet’s native currency and LN emerges as the official network of bitcoin commerce. Long gone are the days of “people won’t use it because of volatility”; people use it despite its volatility. Fading fast are the days of “it’s a bubble”; each popped bubble uncharacteristically grows back bigger than before. Come are the days of “what is it worth?” and “why is it so volatile?”—a welcome breath of fresh air from the years of downright negation. Both are questions that have recaptured my imagination.
My original bitcoin investment thesis
I dove down the bitcoin rabbit hole in 2016 after some price analysis left me no other option—I had to better understand the underlying asset behind this apparent price asymmetry. At the time, I believed that bitcoin’s potential market value was at least the size of gold’s and likely more; the asymmetry between these two prices, the 2016 price of $1,000 and a gold-tying value of about $400,000, made the interim valuation almost irrelevant. If the price ever reached $50,000, for example, it would surely be because bitcoin was on its way to catch gold in terms of total market value.
Now that we’ve reached $50,000, my apathetic attitude towards interim valuation has changed mainly for two reasons.
Investment decisions are continuous. They don’t happen in a vacuum.
A price target of $400,000 was likely too conservative.
I’m convinced my original investment thesis that bitcoin will eventually catch gold’s total market value stands on firm ground. But an entirely new study of bitcoin valuation is demanded by the investment public—the “digital gold” narrative is stale and desperate for a refresh. This essay is dedicated to the pursuit of that study and is loaded with open-ended questions about where the valuation narrative should land.
Bitcoin’s first major valuation metric
In 2017, bitcoin analyst Willy Woo invented Network Value to Transactions Ratio (NVT), the first serious attempt at an endogenous valuation metric for bitcoin:
we can use the money flowing through the network as a proxy for network valuation
Like valuing a company by measuring its earnings, a property by its rental income, or a commodity by its supply and demand dynamics, bitcoin can be valued by measuring the amount of money transacted on the network. This transaction volume doesn’t include all trading volume; exchanges don’t settle every trade on the primary bitcoin layer, only deposits and withdrawals to and from exchange wallets would factor. NVT calculates raw bitcoin usage, not superfluous trading activity.
A power couple of bitcoin startups, Coinmetrics and Glassnode, capitalized on the new science of analyzing bitcoin’s internal blockchain, or on-chain, data. Data was sliced and diced, formulas created, and models sprouted up as analysts attempted to capture bitcoin’s price by analyzing its underlying metrics. Today, on-chain analysis is rapidly growing in popularity because of the ability it gives traders to analyze many components of the behavior of bitcoin buyers and sellers.
PlanB and the S2F model
The bitcoin valuation whisperer, analyst PlanB, released a statistical model based on bitcoin’s supply schedule and scarcity in 2019 that is still turning heads today. His stock-to-flow (S2F) model pins bitcoin’s valuation on the introduction of its supply, resulting in a higher price over time as bitcoin’s new flow of coins declines in relation to the total stock in existence. The model, so far, has shown a remarkable fit. It correctly forecasted a price of $55,000 to occur after the May 2020 halving and currently points to a $288,000 valuation after the next one by 2024. The model considers bitcoin a precious metal substitute; PlanB uses historical gold and silver S2F data to substantiate his model. His analysis considers bitcoin a commodity, and his valuation methodology is supply and demand driven. His analysis gives the value-from-scarcity argument firm credence among bitcoin holders and is somewhat a derivative of the “digital gold” valuation narrative itself.
While bitcoin analysts and data providers dissect on-chain and exchange data for insight and price indicators, mining activity arguably underpins bitcoin’s entire valuation. Without the energy required to discover new coins or confirm transactions, bitcoin wouldn’t provide a secure global monetary network on which to transact. Hash rate simply cannot be omitted from a conversation about bitcoin’s valuation because the higher the hash rate, the more likely it is that people around the world will trust the denomination for savings and economic activity. Hash rate must contribute to bitcoin’s value.
Bitcoin’s hash rate and price periodically show correlation, leading to a heated debate about the direction of causation between the two. (While a higher hash rate causes the network to be more secure and theoretically supports a higher value, a drop in price could trigger a decline in hash rate as miners leave the network due to unprofitability.) Nevertheless, bitcoin mining and associated energy consumption secure a monetary system free from governments and banks, feasibly the entire value proposition of bitcoin.
I wish I had the resources to conduct a continuous study measuring the number of bitcoin users around the world, but I don’t. Instead, I scour the internet for research on the topic and am unfortunately left with static numbers for long periods of time. The latest numbers (from September 2020): across wallets, exchanges, and cryptocurrencies, estimates are now up to almost 200 million people around the world that are exposed to this new bitcoin-based monetary system. I believe this number is heading to a billion people within the next two years, and I fear that waiting for these expansive but infrequent surveys won’t reveal just how rapid and widespread bitcoin adoption really is. What does the explosion of the number of users alone do to bitcoin’s valuation? Asia, Europe, Africa, and South America all have countries with higher cryptocurrency adoption rates than the United States, which already has 13% of its citizens trading cryptocurrency. Soon enough, every merchant that accepts Visa or MasterCard will also process bitcoin payments without having any obligation to use or hold cryptocurrency. Major jurisdictions will resist the restriction of bitcoin-denominated activity, such as in Singapore, Switzerland, and the US, making its spread inevitable as opposed to being subject to regulatory red tape and banned by authoritarian governments.
You might be wondering what type of analysis this is given that I’ve presented more questions than answers. But that’s exactly the point here: an honest study of bitcoin valuation reveals that its growth stems from a multitude of firm roots. Some of the roots are easier to value with on-chain and hash rate analysis, and others are harder to quantify, like the network effects taking place right now as bitcoin fully captures the world’s attention.
Willy Woo’s price model shows NVT at about $30,000 today, while PlanB’s S2F projects a $100,000 price over the next several months:
It is only now that we can finally begin to answer the question many traditional investors have about bitcoin once they understand its relevance to society and its place in our monetary future: why is it so volatile? The answer: nobody knows how it should be valued. If two of the most regarded price models suggest a hefty $70,000 variance, extreme volatility should be the baseline assumption for bitcoin’s price behavior.
The science of bitcoin valuation is young and diverse; on-chain analysis will become its own industry as the logos of cryptocurrency exchanges replace those of banks and insurance giants across uniforms of televised athletes around the world. Given potential competition with over 200 government currencies and 4 billion internet users yet to use it, bitcoin is poised for much more price discovery over the next several years. I imagine that government currencies will cease to exist in countries without globalized economies, as people conduct online commerce in either BTC or USD-linked stablecoins instead of unstable and non-digital government currencies. I also believe that an entire generation, already born, is unlikely to ever have a relationship with a traditional bank and will manage cryptocurrency wallets before ever using a credit card or paper cash. In these scenarios, bitcoin will emerge as a world reserve currency, knocking on the door of the dollar. How would you value that?