Along with increased awareness in the general population about what Bitcoin is, there has been a rise in interest in how it should be valued. The jury is out on this controversial problem, but a few valuation methods are gaining more support than others.
Comparable analysis values Bitcoin by comparing it to similar assets in worldwide markets. Most often, this means gold or US M2 Money Supply (how much US currency circulates in the economy)
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The rationale behind comparing Bitcoin to gold is that both can be used as a store of value. The rationale behind comparing Bitcoin to US M2 Money Supply is that both can be used as a medium of exchange. In July this year, New York University’s finance professor Aswath Damodaran, often referred to as Wall Street’s “Dean of Valuation”, predicted that digital currencies will eventually be as important as the major paper currencies. He also said that digital currencies has already replaced gold for younger investors.If you agree with Damodaran’s predictions and assume that younger investors will use Bitcoin as a replacement for gold, the market cap of Bitcoin should be at least 2% of the market cap of gold.[table id=4 /]
If Bitcoin becomes as important as major paper currencies like Damodaran suggests, then its market cap should be at least 1% of US M2 money supply.
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The advantage of comparable analysis is that it is relatively simple. The disadvantage is that it is not very rigorous. Comparable analysis is essentially back-of-the-napkin calculations that rely on somewhat-vague assumptions (such as how big Bitcoin will be relative to gold or US M2 Money supply in the future).
Overall, comparable analysis is an interesting tool, but it oversimplifies too many factors for professional calcuations.
Quantity theory method applies macroeconomic theory to currency valuation. According to basic macroeconomic theory, the price of a currency can be determined by the following equation:
Value of a Currency = Total Value of Goods Bought Using the Currency in a Year / Total Units of the Currency Spent in a Year
Adjusted, the above formula becomes:
Price of a Bitcoin = Total Value of Goods Bought Using Bitcoin in a Year / Total Units of Bitcoins Spent in a Year
Where:
Total value of goods bought in a year is the sum of the value of all purchases made using Bitcoin in a year, and;
Total spend in a year refers to the total number of Bitcoin that were transacted in a year.
For illustration, let’s suppose that Bitcoin is used for $1.5T worth of transactions.
To identify the number of Bitcoin spent in a year, multiply the total supply of Bitcoin by the number of times the average Bitcoin changes hands in a year. The total supply of Bitcoin on the market today is about 17M, and the average Bitcoin changes hands 11 times each year (based on analysis by CoinCap and CoinMarketCap that 3% of Bitcoins change hands each day).
Multiplying the total supply of Bitcoin by the 11 shows that 187M Bitcoin are spent each year (17M Bitcoin X average Bitcoin is spent 11 times per year).
Using this information:
Price of a Bitcoin = Total Value of Goods Bought Using Bitcoin in a Year / Total Units of Bitcoin Spent in a Year
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The quantity theory of money is a proven method for valuing currency. However, the total Bitcoin expenditure value in a year can be very difficult to estimate.
One of the first valuation measures for stocks is the Price/Earnings ratio, which is equal to the market capitalization of that company divided by the company’s annual net income.
A key insight is that the P/E ratio compares the price of a company against the company’s utility to shareholders. Many financial analysts believe that Bitcoin’s utility to unit-holders is the ability to move money.
Based on the belief that Bitcoin’s core utility to unit-holders is the ability to move money, a proposed analogue for P/E ratio for Bitcoin is a Price/Daily Transaction Volume ratio. This is equal to the the market cap of Bitcoin divided by 24-hour trading volume.
Using Price/Daily Transaction Volume Ratio, Bitcoin’s valuation decreases over time. Currently, its Price/Daily Transaction Volume sits at around 45.
Depending on how you interpret this trend, Bitcoin was extremely overvalued in the past or is undervalued in the present.
Price/Daily Transaction Volume Ratio makes it an easy-to-calculate proxy for measuring the value of Bitcoin as a currency. Since Bitcoin is still relatively new, though, nobody knows what a high or low value for Price/Daily Transaction Volume is or where it will settle.
Different people choose different valuation methods based on what they know, are comfortable, or can easily calculate.
Enthusiasts, for example, prefer valuation method one (comparable analysis) since it is simple to explain and understand. Economists, on the other hand, prefer valuation method two (quantity theory of money) since it applies mainstream economic theory. Business Analysts prefer valuation method three (“P/E ratio”) out of familiarity to what they would use when valuing businesses.
In reality, the Bitcoin community has not chosen a single valuation method.
Different camps apply different valuation methods according to what makes most sense from their perspective. Ultimately, it's up to each individual investor to decide which valuation method works for them.
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Editor’s Note: The goal of this article is to discuss possible methods of valuing Bitcoin. This article may not be exhaustive, and Coinsquare does not endorse any specific valuation method.
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