How to Value Bitcoin
The purpose of a valuation is to find the intrinsic value of an investment. The discounted cash flow method can evaluate investment targets with stable cash flows, such as companies and bonds. The company's value can be estimated by forecasting the future cash flows generated by a company and discounting to their present value based on the time value of money.
Discounted cash flow valuation is widely used in stock investments because it aligns with the core principle of enterprise value, which is that the value of a company should reflect the value of its future cash flows.
However, valuing an investment without cash flows becomes more tricky. For consumable commodities like agricultures, or industrial commodities like crude oil, copper, and iron ore, the main valuation methods are cost-based and supply-demand analysis. The value is determined based on the production cost, processing cost, transportation cost, and an appropriate profit margin. Along with considering costs, analyzing supply-demand relationships, market expectations, global policies, and geopolitical environments is necessary.
Valuing stores of value and currency substitute investments, such as gold, becomes even more tricky. Gold is not a consumable item, and there is no demand for gold in industrial production and daily life. Numerous factors, such as mining costs, supply-demand relationships, global geopolitical situations, inflation rates, and safe-haven sentiment, influence the price of gold. Ultimately, gold itself has no intrinsic value; its value is a consensus reached by humans over thousands of years as a store of value.
Bitcoin's value proposition is digital gold, a store of value and a substitute for fiat currency. It belongs to the investment category that is most difficult to estimate the intrinsic value. No method or formula can accurately estimate the intrinsic value of Bitcoin, but some mental models can provide investors with a rough judgment of its value potential.
Method 1: Pure store of value - Digital gold
Apart from speculating about short-term price fluctuations, the best way to invest in gold is to hold it permanently. Although the price of gold may fluctuate in the short term, the long-term price always rises relative to fiat currency.
It is not that gold becomes more valuable, but inflation depreciates fiat currency.
One ounce of gold 100 years ago could buy the same physical assets as today, while the global currencies have depreciated by over 99%.
Among all cryptocurrencies, Bitcoin has the most robust consensus, the most decentralized network, scarcity, and immutable characteristics, which create the value proposition of digital gold (in the rapidly evolving Web3, many people feel that Bitcoin's development is slow, but stability, security, and the pursuit of decentralization are what make it digital gold).
Assuming that the value proposition of Bitcoin as digital gold will be widely recognized, comparing its adoption rate with that of gold is a simple valuation method.
According to Credit Suisse's estimation in 2022, the total value of global wealth is approximately $463 trillion, including stocks, bonds, real estate, cash, etc. The total market value of gold globally is $12 trillion. So, gold represents 2-3% of global wealth.
One method used by gold analysts to estimate the price of gold is to assume that due to severe inflation or geopolitical tensions, the war risk increases, and people prefer to hold a more significant proportion of gold in their assets. So, assuming the proportion of gold in global wealth increases from 2-3% to 4-6%, and considering the small annual amount in the new production of gold, a doubling of the asset allocation percentage leads to a doubling of the price per ounce of gold.
If Bitcoin only reaches 10% of the total market value of gold ($1.2 trillion), then the price of Bitcoin would be $57,142.
And if Bitcoin reaches 50% of the total market value of gold ($6 trillion), the price of Bitcoin would be $285,714.
For asset allocation recommendations, the suggested allocation of gold in investment portfolios is typically around 5-10%. This allocation ratio is suggested by large asset management companies, such as BlackRock, as advice to clients during the asset allocation process. The reasons for recommending the allocation of gold in investment portfolios are twofold. Firstly, gold serves as a hedge and diversification against risks in the portfolio. Secondly, large asset management companies usually have their own gold ETF products, such as BlackRock's iShares Gold ETF, so recommending clients to allocate gold promotes their products.
BlackRock and other major asset management companies have recently applied for Bitcoin spot ETF products. If successful, this could significantly enhance the position of Bitcoin in asset allocation. Thousands of investment advisors would start to sell Bitcoin spot ETF products and promote Bitcoin as an essential part of investment portfolios.
Method 2: Stock to Flow (S2F) Model
The Stock to Flow (S2F) model is a commonly used method for valuing commodities. Stock refers to the current total inventory of a commodity, while flow refers to the annual new production of that commodity.
For agricultural products and various industrial metals, the ratio of stock to flow is typically less than 1, which means that the total inventory of these commodities is usually less than the annual new production. Agricultural products can only be stored for a short period, and industrial metal storage costs are high, with a risk of rusting. Therefore, producers typically produce an appropriate quantity based on the projected demand for the next six months or one year.
On the other hand, commodities like gold, which serve as stores of value, are very different. There are approximately 187,000 metric tons of gold in the world, representing the total amount of gold mined over thousands of years. Once gold is mined, it cannot be destroyed and will exist indefinitely. The annual new production of gold is around 3,000 metric tons.
Therefore, the Stock to Flow ratio for gold is calculated as 187,000 / 3,000 = 62.3. This ratio means that the amount of gold stored in vaults or held by individuals worldwide equals 62 year’s production. When you invert this ratio, 3,000 / 187,000 = 1.6%, which indicates that the annual inflation rate of gold is approximately 1.6%.
One significant characteristic of Bitcoin is that the new supply entering circulation each year is predetermined. This means that both the stock and flow of Bitcoin can be precisely calculated, whereas other commodities rely on less accurate production estimates. The total supply of Bitcoin is 21 million, with 19.41 million already mined. New bitcoins are mined as miners validate transactions on the blockchain, following a predetermined schedule. The last bitcoin is expected to enter circulation around 2140.
Miners receive a reward of 6.25 bitcoins per block, with a new block mined approximately every ten minutes. This results in annual mining of 328,500 BTC. The current Stock to Flow ratio for Bitcoin is roughly 59 (19.41 million / 328,500), which is very close to the ratio for gold (62).
As the production of Bitcoin halves every four years, the next halving is expected to occur in May 2024, reducing the block reward to 3.125 BTC. This means that the flow of Bitcoin will be halved, doubling the stock-to-flow ratio.
Bitcoin halving leads to a significant reduction in newly produced bitcoins. If the investment demand for Bitcoin remains unchanged while the supply decreases, scarcity increases, driving up the price of Bitcoin.
PlanB's Bitcoin Stock to Flow model charts the price of Bitcoin with the stock-to-flow ratio. The yellow line in the chart represents the model-calculated Bitcoin price, while the colored line represents the actual Bitcoin price. PlanB's S2F model demonstrates a close relationship between the price of Bitcoin and the stock-to-flow ratio for quite an extended period.
It was reasonably accurate until the peak of the previous bull market in November 2021, when the Bitcoin price reached $69,000. However, after a series of adverse events in the cryptocurrency market in 2022, the market entered a prolonged bear market, and the price of Bitcoin has remained below the model's projected price. According to the model, the current price of Bitcoin should be $100,000.
Method 3: Bitcoin Price and Global Monetary Supply
The price of Bitcoin is closely related to the global liquidity situation. Data from the past decade has shown that periods of increasing global monetary supply correspond to upward Bitcoin price cycles. In contrast, periods of decreasing global monetary supply correspond to downward cycles in the price of Bitcoin.
The monetary policies of major economies worldwide are currently in a tightening cycle. The interest rate of the US dollar is approaching 5%, and the interest rates of the British pound and the euro are also above 4%. With such high risk-free interest rates, investors' willingness to invest in Bitcoin, which exhibits significant price volatility, is likely to decrease. This will continue to hurt the price of Bitcoin.
No method can accurately predict the price of Bitcoin, and the methods mentioned in this article are just examples among many Bitcoin valuation methods. Each method has its rationale and limitations.
For example, in a period of global liquidity tightening, does Bitcoin price necessarily have to decline? If the proportion of Bitcoin as an asset allocation increases, from the current almost non-existent allocation by traditional and institutional investors to a small portion of investors starting to allocate, then even in a poor macroeconomic environment, Bitcoin can still benefit from an increase in adoption and therefore rise in price.
Similarly, the increase in the stock-to-flow ratio caused by Bitcoin halving, combined with a significant decrease in newly produced Bitcoins, can also boost Bitcoin's price if investment demand remains constant while supply decreases.
Finally, after all the discussion, you may want a straightforward opinion on whether Bitcoin price will rise or fall. The interest rates of major economies are approaching their peaks, and the tightening cycle may continue for some time, but the possibility of further substantial interest rate hikes and tightening is very low. The recognition of Bitcoin as an investment asset has been slow. Still, if major asset management companies can launch Bitcoin spot ETFs, it will have a significant positive impact on adoption rates. The next Bitcoin halving is less than a year away, and the current price is still far below the calculated price based on the S2F model from the previous halving cycle.
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