Thoughts on bitcoin valuation and the bursting of the crypto bubble
I have been an outspoken fan of blockchain technology (as far as I can understand it as a non-coder), bitcoin and the entire cryptosphere pretty much since 2011/12. More recently, my published opinions have veered to the bearish side more often than not, because I just see too many parallels in what is going on right now to what happened in the .com bubble.
In the articles above you can see both the reasons I think we are in a (bursting) bubble as well as my last thoughts on bitcoin price.
I’d like to go a little further today and actually try and come up with a valuation for bitcoin.
Attempting to put a value on bitcoin
Of course, I am not the first one to try putting a value on bitcoin. The article I found most helpful is linked here, but there are many others and so I am just adding my own ideas to the discussion. I will attempt to look at three ways that I can think of to value bitcoin and maybe even the entire crypto space.
Economic Value
I will start with the obvious one. What happened during the .com bubble was that everyone claimed that the internet is different and that traditional valuation metrics like the Price/Earnings (PE) ratio did not apply. So let’s just assume, as has been proven time and time again that this is just as wrong for crypto as it was for internet stocks. So what would bitcoin’s PE look like?
The Price/Earnings ratio is the ratio of stock price divided by Earnings per share after taxes. Basically it gives you the multiple that people pay of a company’s current earnings to own that company. For growth stocks it can be as high as 40x (in a bull market), while struggling industrials might trade around 6–8x.
The price of bitcoin is easily found. At the time of writing it is about $200bn. In order to understand the earnings of bitcoin, we need to take a look at the earnings generated by the network:
Granted, the profit margin is an assumption, but as I am trying to get an idea of the current value, an optimistic (80%…) profit margin is not necessarily the wrong thing to look at. You could look at the profit margin for miners, but given their input (block reward) is a bit different, I think the above is not so far off the mark.
So the annually generated value of bitcoin, assuming transaction stats as of January 30th is about $400m. Applying a growth stock multiple of 40x (which takes care of future growth; so using today’s stats is fine here), gets me to an economic value of $16bn. This compares to a current market valuation of $200bn. Even if I apply a multiple of 100x, the level many .com firms traded on back in the bubble, I only get to $40bn.
For arguments sake, let’s also look at Ethereum’s economic value and ADD it to the numbers for bitcoin. Why? Because Ethereum is currently the most likely blockchain to be used as a backbone to the new decentralized web and applications and given bitcoin is likely to implement most of Ethereum’s features over time and add some others (privacy, lightning, smart contracts, etc) there is a case to say that bitcoin should really absorb that value as well. Not that I share that view necessarily, but it is a valid argument.
Looking at the Ethereum network, we get to a current annual network profit of c. $300m. So let’s add that to bitcoin’s $400m and even round it up to an even $1bn in annual profits.
Applying a 100x multiple (itself a “bubble multiple”) gets us to $100bn economic value for both Ethereum and bitcoin, as well as a number of other cryptos that have been included given the value was “rounded up” by 50% to $1bn annually.
My conclusion is that the crypto markets are overvalued by a factor of 3–5x according to this method and the “traditionally derived” value of bitcoin should be around $2000. As an aside, using a traditional Discounted Cash Flow (DCF) method here and simply assuming 1bn as the annual cash flow and using a very low discount rate of 2–3% still gets you to similar values.
As a side note, consider that the cryptosphere in total is currently valued at about the same as Google or Apple. Those companies, however, churn out profits of $10–20bn per quarter…
Technology/Network Value
Looking at the past, it is more than likely that the above section I called “Economic Value” will prove to be closer to the truth than anything else, but for the sake of argument, let’s look at bitcoin in a different light. As is frequently pointed out, bitcoin is only the unit of value of the Bitcoin network and that is more comparable to TCP/IP than it might be to traditional companies etc. So let’s assume just that — let’s say that all the people who say “Imagine you held the keys to the internet” are right. We are assuming Bitcoin becomes the new internet and drives everything we do online.
To derive its value, we would pretty much need to value TCP/IP. As I said at the beginning, I am not a coder so this is unfamiliar territory for me and has a huge potential for embarassment, so please be gentle… I will try to use a similar metric as before in terms of valuation, except I will not assume a profit margin. I will assume 100% of revenues are profit and I will also look at this as a “steady state” valuation, ie assuming the internet stats today are where Bitcoin will go in terms of usage and as mature companies are often valued at 1x Revenues this is not necessarily the wrong metric.
In order to estimate this, I will use Google, the pre-eminent internet company as a basis. I found various different statistics regarding google’s share of total internet traffic, but from what I see, 15% of global traffic seems in the right ball park.
Now we are talking, right? $650bn in annual value, which we should probably compare with the entire crypto market cap of around $800bn today (if you do not see where that number comes from, check out my earlier article on crpyto market cap before you comment that it is wrong).
There are several issues I have with that value. The most important one is that blockchains can be forked and it is simply wrong to assume that, IF TCP/IP itself were valued like that, that there would not be several different TCP/IP competitors and the standard would be watered down. Also it assumes 100% profit, which given energy usage of Bitcoin is clearly incorrect. Looking at the crypto space right now, the plurality of blockchains is already happening. You can argue that everyone will default to Bitcoin once it has incorporated all the features of the other chains, but you can argue just as easily that there will be at least 20–30 steady state blockchains out there.
Anyways, using my own (possibly very skewed) technology value estimate, the cryptospace currently seems at least fully valued. Remember this actually assumes that the internet has moved to the blockchain. Completely. So I’d put a discount on that value.
Monetary Value
The last valuation method that is outstanding in my view is looking at bitcoin from a monetary point of view. There are two sides to this, namely bitcoin as a store of value and as a medium of exchange.
Bitcoin as a medium of exchange would imply that it becomes as valuable as the entire fiat we use today. Currently, there are about $4.5 trillion of coins and banknotes in circulation worldwide. So assuming bitcoin becomes the new medium of exchange, that is the value we should assume. We might even need to go higher, given that one probably needs to apply a money multiplier of 3–4 to that number.
I have a major issue with assuming bitcoin becomes the world’s medium of exchange. I am happy to leave all the political dimensions of this aside (countries fighting this development by numerous means, such as raiding mining operations or putting owning bitcoin and using it under harsh penalities). My main issue is that I do not think bitcoin is able to act as both a store of value and a medium of exchange at the same time and I believe that becoming a medium of exchange is the less likely of the two. Of course I may be wrong, but consider this:
Bitcoin is interesting to most people, because its price is rising (or was rising?). In order to be a medium of exchange, it would need to be accepted legal tender (companies offering the services we want operate in jurisdictions that have rules…), widely distributed and most importantly slightly INflationary.
We have been in a world with a deflationary currency before. It was called the gold standard and it ended very poorly. Bitcoin very much has the same exact flaws. In my view, these are the most dangerous ones:
- Once all coins are mined, there will be people who own bitcoin and people who don’t. There will be no method to truly re-distribute wealth, which robs people with bitcoin of any incentive to work and those without of the possibility to gain any. In essence we would be replacing one system already skewed towards a few individuals with another (yes, the current system is not perfect), skewed towards an even smaller number of people or at least a similarly unjust distribution
- Bitcoin is designed to be deflationary, meaning the prices of goods and services constantly keep going down in bitcoin terms (in theory). This means the people who hold coins have no incentive to spend it. To this day, I see none of my bitcoin friends using it as a payment method. The currently almost empty blocks are actually another symptom of that. And who would want to spend something that you bought because you think it will double in a year anyways…
- The central method of our current economy to be able to generate wealth is to have a brilliant idea and work very hard at it to make a business out of it. If you do not have funding, you need to either sell equity in your business or take out a loan. If your loan, however, is denominated in bitcoin, you will have an extremely hard time ever paying it back unless it becomes an inflationary currency. Similarly, loans in bitcoin will be extremely hard to come by, as people are simply hoarding it, making it just as unlikely they invest it.
All this, in some way or other, helped to bring about the collapse of the gold standard and I think that bitcoin as a medium of exchange for products and services is a total non-starter UNLESS it becomes an inflationary currency, giving those who hold it an incentive to invest it in order to preserve their wealth. That however, would not sit too well with current “hodlers” (Nota bene, I wonder how much the constant “issueing” of new crypto is already inflating crypto more than any fiat ever has been inflated).
Bitcoin as a store of value is a different story. I actually believe this is bitcoin’s best chance of justifying its current valuation. If bitcoin were to truly replace gold as a global store of value, each bitcoin would be worth approximately $350,000.
That is not totally out of the question. The main issue with this view has actually been pointed out by someone else here on Medium but sadly I just cannot find the article right now (anyone who found it, let me know and I’ll link it). The point is that even though we now reasonably assume that Bitcoin cannot be hacked (leave aside a 51% attack which given the Chinese concentration of mining is not out of the question I believe), time and time again great technology has been hacked and we only learned about the vulnerabilities much later. The latest example is the issue with WiFi networks around the WPA standard. To put it in a nutshell, the issue is risk. Technologically and politically.
If you compare bitcoin to gold, next to its many advantages, a key disadvantage is that bitcoin’s track record is a mere (very, very volatile) 9 years. Gold, which has almost no real advantages over bitcoin otherwise, has been used by humans pretty much since the beginning of history. So while you simply cannot be certain that bitcoin will always be valuable in the eyes of humanity, you can pretty much assume gold will.
As I said, the store of value angle is, in my view, bitcoin’s best shot at higher prices. Currently it is trading at approximately 3% of the value of all gold. That is actually a PREMIUM to its track record length compared to that of gold (which is less than 1%), but if you ask me — that’s fair value.
So in summary, looking at the three valuation methods outlined above, bitcoin and the crypto markets are hopelessly overvalued according to one (the traditional one) and, shall we say, optimistically “fairly valued” according to two other ones if you assume the store of value view for monetary value. Whichever way you look at it, I struggle to build a really compelling investment case currently, aside from the “greater fool” theory, ie saying that “if everyone invests 1% of their assets in bitcoin, it will rise astronomically”. I find it therefore much more likely that the near term future is less spectacular than most people in the cryptosphere would like it to be, despite all the promise in the technology.
Note in passing that the current bitcoin chart looks almost exactly like the Nasdaq100 chart during the .com bubble when it finally burst. I do think that humans’ behavior manifests itself in similar “waves” again and again, so this might not be the worst comparison…
If you take a look what happened afterwards, you won’t see a pretty picture. Let’s see if fake tethers can keep bitcoin from this fate (which I would not rule out; check out www.tetherreport.com while you’re at it).
If you enjoyed reading this, you can clap and follow me on twitter. Below is the archive of my crypto writings too:
As always, a short but important disclaimer: none of what I write here is to be construed as advice to buy or sell any kind of asset. It is merely my personal and not my professional opinion. Any asset can go to zero and just like anyone else, I make mistakes.
