How do you determine the fair market value of a currency that has appreciated faster than the shares of even the hottest technology stocks? This question has befuddled investors and analysts for years when it comes to Bitcoin. While the methods for valuing digital currencies are rather straightforward, the assumptions that underlie competing valuations vary widely. Don't rely on Wall Street analysts to think for you. Instead, consider this framework and come up with your own fair market value estimates for bitcoin.
Bitcoin has value because people think it has value.
Your first question might be to ask whether Bitcoin has any value whatsoever. After all, many bitcoin skeptics have knocked the virtual currency for its lack of "intrinsic value", including world-class investors like Berkshire Hathaway Inc.'s (NYSE:BRK.B) Warren Buffett (who called Bitcoin a "mirage") and J.P. Morgan Chase & Co.'s (NYSE:JPM) Jamie Dimon, and venerated economists like former Federal Reserve Chairman Alan Greenspan and Nobel laureate Paul Krugman ("Bitcoin is evil"). Despite this army of skeptics and a myriad of bad news for the industry so far in 2014, Bitcoin still continues to trade for multiples more than it did one year ago. The Winklevoss twins clearly disagree. See Investopedia's interview with Tyler Winklevoss.)
How can this be?
Quite simply, Bitcoins have value because a small, but growing group of people believe that the underlying Bitcoin technology has value. In the future, the Bitcoin technology may be used for a wide array of financial services applications from payments, to contracts, to distributed exchanges. Since Bitcoins are the scarce currency units which are required to power these applications, they are valuable. Unlike fiat currencies whose money supplies may be inflated by central banks, there are a finite number of Bitcoins that will ever be released into circulation, making the currency a superior store of value versus other international reserves. Although Bitcoin is not legal tender backed by a particular government, the currency's value is supported by the individuals and merchants who voluntarily accept Bitcoin for their goods and services.
If we can agree that Bitcoins have a positive expected value (because at least some people believe the underlying technology has the potential to be revolutionary), we can start to make our own estimates about its current fair value.
Bitcoin's value depends on "transactional" and "reservation" demand.
It is important to note that the total market value of a currency, its "monetary base", is driven by two things, transactional demand and reservation demand. We can think of Bitcoin's average daily "float" as the analog of our economy's M1 money supply - the currency needed to satisfy transactional demand for goods and services. Similarly, we can think of the Bitcoins which are "hoarded" by speculative investors as the currency needed to satisfy reservation demand for secure long-term savings. Combined, Bitcoin's float and reserves comprise its total monetary base, which is similar to our economy's M2 money supply (M1+money in savings deposits, money markets, etc).
So the monetary base relies on both consumers and investors who believe that the Bitcoin technology will power a certain volume of economic exchange today and in the future. Speculative investors in particular have shown an extraordinary willingness to buy BTC, leading to a much larger monetary base than would otherwise be expected for a currency with bitcoin's transactional volume.
And that's ok! As long as the transactional demand for Bitcoin continues to grow exponentially in the coming years, the balance between Bitcoin's float and its total monetary base will likely reflect that of other global currencies. (To learn how Bitcoin enters into circulation, read, "What is Bitcoin Mining?")
Bitcoin's potential monetary base is one key input we need for our valuation.
Since there is no real difference between a BTC held for commerce and a BTC held for investment, it should be clear that we really only care about Bitcoin's total monetary base when it comes to valuation.
Theoretically, the fair-market value of one BTC should simply be the dividend of its predicted future monetary base and BTC in circulation, discounted by a "hurdle rate" an investor would require in order to invest in the speculative currency.
So what are some reasonable estimates for bitcoin's future potential monetary base? Bitcoins are worth about $5.5 billion today, but according to investor and entrepreneur Barry Silbert, they will only begin to thrive as transactional currency once the monetary base grows to $50-100 billion.
More dramatically, analysts at Wedbush Securities recently approximated that the potential aggregate demand for bitcoin could be over $13 trillion, including global foreign currency reserves, money supplies of high-inflation countries, and the market value of all gold held as financial assets.
Let's assume that in our optimistic case for Bitcoin, the monetary base grows to $1 trillion dollars within ten years, which would represent a fraction of the U.S. dollar's total money supply and about half the value of the global market for gold. We could then divide this monetary base by the total number of bitcoins expected in circulation by 2024 (thanks to the known mining schedule). With 21 million BTC in circulation, we could see a $50,000 bitcoin with a $1 trillion monetary base!
If we're comfortable with that assumption, all we need to do is boil down our $50,000 future bitcoin into present dollars.
Bitcoin's "hurdle rate" is the other key input we need for our valuation.
Here's where things get tricky: what is an appropriate discount rate to use for bitcoin, a speculative currency that will never generate cash flows?
We need to make certain assumptions about the rate of return required to compensate for the risks associated with holding Bitcoin. Let's assume that we normally require a 12% return on equity for investments in certain growth stocks, but we believe Bitcoin carries five times the usual risk. We would need to apply a 60% discount rate to our future value estimate for Bitcoin. Due to compounding, that would make our $50,000 BTC in 2024 worth approximately $455 today -- not too far off from current price levels.
For further illustration, it might also help to consider how a venture capitalist could determine the net present value of an investment that he never expects to generate positive cash flows during his firm's investment period (e.g. a high-growth tech company that reinvests 100% of its earnings before it ultimate sells to Google). In the absence of earnings, that VC might look at revenue multiples to determine the company's terminal value, and then discount that figure by a rate of 40 to 60%.
With Bitcoin, the thinking is the same. Except Bitcoin's terminal value is actually its future monetary base.
Caveat emptor: Your assumptions make all the difference.
Under the assumptions we used above, Bitcoin may seem as if it is close to fairly priced today.
But what if we think the monetary base will reach $2 trillion in ten years and investors prove willing to settle for annual returns of 30%? Suddenly BTC's current fair market value skyrockets to $7,250! Conversely, if we think the monetary base will reach just $500 billion in ten years and investors only touch Bitcoin when they expect an 80% annual return, the current fair value would plummet to $70.
The Bottom Line
If you're a risk-tolerant Bitcoin believer, today's prices are probably enticing. If you're a more conservative skeptic, you will likely steer clear of an asset class that looks as if it is in a speculative bubble. But either way, you only need to make two basic assumptions to come up with your own fair market value for Bitcoin: its future monetary base, and your risk-adjusted rate of return. Good luck!
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