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. Despite this army of skeptics, the price of Bitcoin continues to soar, hitting record highs of nearly $20,000 in December 2017. However, it's also very volatile, currently trading at $6,994.80, as of March 31, 2018. 

How Can This Be? 

Quite simply, Bitcoins have value because of a growing group of people who 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

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 the 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 okay! 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.

Bitcoin's Potential Monetary Base

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.
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"

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. 
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 ultimately 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

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%? This would make BTC's fair market value $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 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!

Note: Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.

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