A:

Bitcoin offers an efficient means of transferring money over the internet and is controlled by a decentralized network with a transparent set of rules, thus presenting an alternative to central bank controlled fiat money.  There has been a lot of talk about how to price bitcoin and we set out here to explore what bitcoin's price might look like in the event it achieves some level of widespread adoption.

In this article, we seek to lay a framework for calculating a medium to long term value for bitcoin, and to empower the reader to make their own projections on the value of bitcoin. (Haven't filed your taxes yet because you don't know how to declare your virtual currency? Check out Investopedia's definitive Bitcoin IRS Tax Guide.)

Assumptions 

As part of our framework, we make several key assumptions.

Our first assumption is that bitcoin will derive its value both from its use as a medium of exchange and as a store of value.  As a footnote to this assumption, it should be stated that bitcoin's utility as a store of value is dependent on its utility as a medium of exchange.  We base this in turn on the assumption that for something to be used as a store of value it needs to have some intrinsic value, and if bitcoin does not achieve success as a medium of exchange, it will have no practical utility and thus no intrinsic value and won't be appealing as a store of value.    

Our second assumption is that the supply of bitcoin will approach 21 million as specified in the current protocol.  To give some context, the current supply of bitcoin is around 13.25 million, the rate at which bitcoin is released decreases by half roughly every four years, and the supply should get past 19 million in the year 2022.  The key part of this assumption is that the protocol will not be changed.  Note that changing the protocol would require the concurrence of a majority of the computing power engaged in bitcoin mining. (Related: How Does Bitcoin Mining Work?)

Our third assumption is that as bitcoin gains legitimacy, larger scale investors, and more adoption, its volatility will decrease to the point that volatility is not a concern that would discourage adoption.

Our fourth assumption is that the current value of bitcoin is largely driven by speculative interest.  Bitcoin has exhibited characteristics of a bubble with drastic price run-ups and a craze of media attention in 2013 and 2014.  But speculative interest in bitcoin, we assume, will decline as it achieves adoption.

And our fifth assumption is that the use of bitcoin will never involve fractional reserve banking and that all means of storing bitcoin will be fully backed by bitcoin.

Methodology

We will look at bitcoin as currency and bitcoin as a store of value.  In order to place a value on bitcoin we need to project what market penetration it will achieve in each sphere.  This article will not make a case for what the market penetration will be, but for the sake of the evaluation, we'll pick a rather arbitrary value of 15%, both for bitcoin as a currency and bitcoin as a store of value.  You are encouraged to form your own opinion for this projection and adjust the valuation accordingly.

The simplest way to approach the model would be to look at the current worldwide value of all mediums of exchange and of all stores of value comparable to bitcoin, and calculate the value of bitcoin's projected percentage.  The predominant medium of exchange is government backed money, and for our model we will focus solely on them.  The money supply is often thought of as broken into different buckets, M0, M1, M2, and M3.  M0 refers to currency in circulation.  M1 is M0 plus demand deposits like checking accounts.  M2 is M1 plus savings accounts and small time deposits (known as certificates of deposit in the US).  M3 is M2 plus large time deposits and money market funds.  Since M0 and M1 are readily accessible for use in commerce, we will consider these two buckets as medium of exchange, whereas M2 and M3 will be considered as money being used as a store of value.

Roughly speaking, M1 (which includes M0) is currently worth about 25 trillion US dollars, which will serve as our current world wide value of mediums of exchange.

M3 (which includes all the other buckets) minus M1 is worth about 45 trillion US dollars.  We will include this as a store of value that is comparable to bitcoin.  To this, we will also add an estimate for the worldwide value of gold held as a store of value.  While some may use jewelry as a store of value, for our model we will only consider gold bullion.  The US Geological Survey estimated that at the end of 1999, there were about 122,000 metric tons of available above-ground gold.  Of this, 48%, or 58,560 metric tons, was in the form of private and official bullion stocks.  At an estimated current price of $1200 per troy ounce, that amount of gold is today worth upwards of 2.1 trillion US dollars.  Since there has recently been a deficit in the supply of silver and governments have been selling significant amounts of their silver bullion, we reason that most silver is being used in industry and not as a store of value, and will not include silver in our model.  Neither will we treat other precious metals or gemstones.  In aggregate, our estimate for the global value of stores of value comparable to bitcoin, including savings accounts, small and large time deposits, money market funds, and gold bullion, come to 47.1 trillion US dollars.

Our total estimate for global value of mediums of exchange and stores of value thus comes to 72.1 trillion US dollars.  If bitcoin were to achieve 15% of this valuation, its market capitalization in today's money would be 10.8 trillion US dollars.  With 21 million bitcoin in circulation, that would put the price of 1 bitcoin at $514,000.  That would be over 1,000 times the current price.

This is a rather simple long term model.  And perhaps the biggest question it hinges on is how much adoption will bitcoin achieve?  Coming up with a value for the current price of bitcoin would involve pricing in the risk of low adoption or failure of bitcoin as a currency, which could include being displaced by one or more other digital currencies.  Models often consider the velocity of money, frequently arguing that since bitcoin can support transfers that take less than an hour, the velocity of money in the future bitcoin ecosystem will be higher than the current average velocity of money.  Another view on this though would be that velocity of money is not restricted by today's payment rails in any significant way and that its main determinant is the need or willingness of people to transact.  Therefore, the projected velocity of money could be treated as roughly equal to its current value.

Another angle at modeling the price of bitcoin, and perhaps a useful one for the near to medium term, would be to look at specific industries or markets one thinks it could impact or disrupt and think about how much of that market could end up using bitcoin.  The World Bitcoin Network provides a nifty tool for doing just that.

The Bottom Line

As mathematician George Box said, "All models are wrong, some are useful."  We have set out to construct a framework for pricing bitcoin but it is important to understand the variables.  From our thinking, it seems possible that bitcoin could eventually increase in price by orders of magnitude, but it all depends on bitcoin's level of adoption.  The most important question is "Will people use bitcoin?"

RELATED FAQS
  1. How do you buy Bitcoins?

    Many people have heard of this virtual cryptocurrency, but few know all the ways you can purchase Bitcoin. Read Answer >>
  2. What are the advantages of paying with Bitcoin?

    Learn how payments made with Bitcoins offer certain advantages over standard currency, including user anonymity, no taxation ... Read Answer >>
Related Articles
  1. Tech

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

    How do you determine the fair market value of a currency that has appreciated faster than the shares of even the hottest technology stocks?
  2. Tech

    How Bitcoin Can Change The World

    Bitcoin has the potential to not only create savings for consumer, but also to transform global transactions.
  3. Tech

    How To Trade Forex With Bitcoin (XOM, EXPE)

    We look at ways to trade forex with bitcoin and the pitfalls in doing so.
  4. Tech

    The Rise And Fall And Rise Of Bitcoin

    A look at the reasons behind the recent spectacular surge in bitcoin prices.
  5. Tech

    When Will Bitcoin Soar?

    We look at what determines the value of Bitcoin, the digital currency, and when it might take off.
  6. Tech

    What Bitcoin Regulations Look Like Around The World

    Bitcoin is still so new that countries are struggling to make legislation catch up with technology. Some nations are more open to virtual currency than others.
  7. Tech

    Benefits & Risks of Trading Forex with Bitcoin

    Want to trade forex using bitcoins? Don’t jump on the bandwagon until you compare the risks to the benefits.
  8. Tech

    Bitcoin's Main Stumbling Block: Navigating The Law

    Coders created Bitcoin to be decentralized and independent of governments and banks. Authorities are still struggling to create a legal framework.
  9. Tech

    The Outlook for Bitcoin in 2016

    A look at the forces behind the recent surge in Bitcoin price and how it stands entering 2016.
  10. Tech

    Bitcoin Price Holds Steady But Future Spike May Be In The Cards

    Bitcoin's price remained steady even as bitcoin cash gained more than 11% in the last 24 hours.
RELATED TERMS
  1. Satoshi Cycle

    Satoshi Cycle is a crypto theory that denotes to the high correlation ...
  2. Bitcoin Exchange

    A bitcoin exchange is a digital marketplace where traders can ...
  3. Bitcoin Unlimited

    A proposed upgrade to Bitcoin Core that allows larger block sizes.
  4. Bitcoin Classic

    A fork from Bitcoin Core that proposed increasing the size of ...
  5. Trade Hill Exchange

    A Bitcoin exchange launched in June of 2011. Trade Hill Exchange ...
  6. Bitomat

    A Polish-based bitcoin exchange. Bitomat was the first Bitcoin ...
Trading Center