A Very General Theory on How to Value Bitcoin and Other Cryptocurrencies
Some claim that Bitcoin’s value comes from speculation alone, but there are fundamentals to consider too. We discuss how to value Bitcoin and other cryptocurrencies.
Below we will use Bitcoin as an example, and then will use other examples like Ethereum when points apply to other technologies not present in the Bitcoin system. Generally though, this logic applies to all cryptocurrencies (although each has its own unique features).
How to value cryptocurrency in summary: Bitcoin like other cryptocurrencies can be valued based on factors including number of transactions in a day, transaction speed, transaction cost, utility (cryptos are software that act has decentralized databases and ledgers with native tokens), cost of mining, demand, current market cap, potential market cap, scarcity, scalability, work put in (by developers and miners), price and volume trends, and more. Despite this, the market price of cryptos comes almost solely from speculation on the exchanges (although that speculating is notably impacted by fundamentals, the cost of mining crypto, the news of the day, etc).
On the cost of mining: Since crypto requires miners to mine it, we can say a current fair value of a given crypto is the mining cost. The only problem with using this value is that mining difficulty increases when more miners attempt to mine a coin and decreases when less miners try (thus, this cost is fully dependent on competition in mining). Still, if miners are losing money by mining, or if mining is very profitable, it can hint that a crypto is oversold or overbought.
On quantity theory of money: Another way to look at this is through the lens of the quantity theory of money. Roughly this would be done by factoring the total supply, velocity of transactions, and the cost of the goods and services a crypto is used for. The problem with this is that even a generous output probably falls short of the cost of mining and fails to account for crypto as a store of value (plus it can be difficult to properly gauge the value of peer-to-peer transactions).
Opinion on considering a range of factors to determine value: Given the complex nature of crypto and the different ways to value it, it makes the most sense to consider all these factors and more and to try to come up with a standard model for finding a fair market value of Bitcoin and other cryptos (which can then be speculated on based on factors like growth potential). Until that happens, people will continue to treat Bitcoin like it could be worth $20 or $2 million dollars, which essentially makes Bitcoin a poor payment system and an incredibly unstable store of value… and instead just makes it a gambling chip of sorts. To the extent that other coins follow Bitcoin, which every coin except for a stable coin like Tether does, is to the extent that this is true for literally all other cryptos. This systemic, but not fundamental problem, is arguably rooted in the inability or unwillingness of people to properly price a Bitcoin using a rational system.
Factors That Speak to the Value of Bitcoin and Other Cryptocurrencies
The following is a list of factors that impact the value of Bitcoin and other cryptocurrencies in one way or the other. The goal will be to create a complete list over time.
This section will be focused on listing factors that give cryptocurrency value. It will not be an attempt at tying them together with some magic formula that outputs the true value of a given cryptocurrency (to be fair, if I had a magic formula, I’d share it; I do not).
Basics: First and foremost, in-practice, the value of cryptocurrencies comes from speculation on the market. Simple as that. However, even that speculation is based on factors like supply and demand. Beyond that, some basic and obvious fundamentals that can be used to value cryptocurrencies include the number of transactions in a day, transaction speed, transaction cost, the cost of mining a coin at the current difficulty level, and the overall quality and usefulness of the software in terms of the function it intends to serve compared to how we value entities who preform those functions in other markets (for example how we value a software company or bank). A lot of the functions cryptocurrency preforms cost a great deal of money to preform in other walks of life and the execution of those services is highly valued in other markets. For example, compare the functions of online banking to Bitcoin or Square and PayPal to Bitcoin. These all serve many of the same purposes, we could make an argument for the fundamental value of a bank or payments company, and it isn’t so different for Bitcoin if we factor out what they don’t have in common. Beyond this we can consider a range of concepts pertaining to the attributes of coins and their use-values. Meanwhile, we can also consider the values of other stores of value vs. potential market cap. Some of those points will be covered below under different categories.
Cryptocurrencies are like Semi-Corporeal and Incorporeal Corporations: Bitcoin isn’t a company, but it functions a lot like a decentralized and distributed company. A bit like a mix of online a digital payment system tech company (like PayPal), commercial online bank, central bank, government, and treasury. Its board consists of everyone running a copy of the blockchain, its accountants are miners, its investors are anyone who holds even a fraction of a Bitcoin, its users are anyone who uses Bitcoin, its dividends are forks, its market cap increases as demand increases, its image and standing in the world affects its value, the value increases as the technology updates and improves (thereby improving user experience), etc. It lacks many features of a corporation with a public stock (which represents a share of the company)… but it also has a lot of features that banks, governments, and tech companies have, and we value those all very highly (and not just because we care about how their bottom line affects the value of their stock). It makes sense to value Bitcoin in this way, but accounting for its obvious differences. MUSING: If cryptocurrencies were tech companies, Bitcoin, Ethereum, and Ripple would probably be the FANGs of the crypto world (hmmm, maybe through ADA in there and call it BEAR). That said, Ripple actually is a company (although the XRP token is not a share of Ripple).
NOTE: Valuing cryptocurrency is more akin to valuing a currency than a stock of a company, but there are parallels. In both cases the entity that issues the currency, with Bitcoin code and with a state the state, is essentially equivalent to a company. How different is Zuckerberg + Facebook + Facebook stock compared to Trump + U.S. + the U.S. Dollar compared to Bitcoin Developers and Users + Bitcoin the brand + Bitcoin the currency ? Each is unique, but not in every respect. In each case it is a basket of interconnecting aspects, each affecting the value and together creating a brand.
Utility: What is the intrinsic value of a federal reserve note or bank credit? It’s close to the intrinsic value of a Bitcoin I’d imagine. That is, its intrinsic value is equivalent to “the particles its is printed on.” Stores of value and mediums of exchange aren’t meant to themselves have intrinsic-value or use-value beyond being a medium of exchange, they are meant to be representative of value so other items with use-values can be exchanged using this third widget “in the money form” (to avoid everything being a direct trade like wool for meat). Instead of trading meat for wool, we trade meat for Bitcoin or bank credit, then later use that Bitcoin or bank credit to buy wool. It is way more useful, and as a bonus it allows us to have another widget speculate on and with! The fact that a medium of exchange can preform this intermediary function is its primary utility. The fact that the public ledger can account for all transactions and balances is also a utility. The fact that it is done via trustless financial contracts between peers online across the world (and thus is a global payment system) is utility. The fact that it can be done quickly and at low fees (was true before, and with segwit and LN should be true in the future) is utility. Every aspect of the software that preforms a useful function, and all useful things that can be done with Bitcoin are its utility. Utility creates value. Other cryptocurrencies like Ethereum, which includes a whole decentralized software creation platform which can host decentralized apps, other types of “smart contracts” beyond financial ones, and can be used to create other coins has even more utility (and is more like a mostly decentralized and distributed tech company than Bitcoin). At the end of the day we need a medium of exchange. It could be Conch shells, or dollars, or gold nuggets, or goats. But, since we live in a digital global society, and since goats are hard to fit our wallets, why not go with bank credit, payment systems like Square and PayPal, and cryptocurrency? Being able to use tokens and digital ledgers as mediums of exchange, and being able to use smart contracts in place of real ones, and being able to use a distributed network to program and host apps, and everything that arises from it is utility… and thus fundamental value. MUSING: If crypto was only valued off utility, then a coin like Ripple would be #1 for payments, Ethereum #1 for overall utility, and Litecoin would have a higher market cap than Bitcoin (it is faster and cheaper to use). However, value doesn’t just come from one metric.
NOTE: Bitcoin is like the reserve currency of the crypto space. That gives it value in the crypto economy. Ether also preforms a similar function to a lesser extent. Meanwhile, Tether does as well, but it is a stable coin (a utility), is partly centralized, and doesn’t act as a growth investment.
NOTE: Let’s not ignore the fact that a coin like XRP is probably the quickest and easiest currencies to send on earth. Its a universal currency that can be sent in instants to anyone via the internet via a trustless financial contract. That has real utility and real value. That value might not directly speak to how much a token trades for, but it does have some relation with the whole system the token is representative of.
NOTE: To expand on the last few points, stock in a company represents partial ownership of a company. We look at the products that company has and see their use-value, and part of the value of the company is based on that. However, part of the value is from the return those products can provide for the company (and thus us indirectly via the stock). So with a public company, there is a direct link between use-value of their products, their bottom line, and the value of our stock. This isn’t exactly the same for cryptocurrency, but it does have a lot of the same moving parts. Like XRP and Ripple, the value of the company doesn’t speak directly to the value of XRP, but we can denote the relationship and muse on how this affects the value of XRP.
Demand and Use Within an Ecosystem: Many cryptocurrencies are native to an ecosystem and some even act as the main currency in a given economy. For example, KIK messenger has a native token called KIN, the usage of a token within an ecosystem can help to dictate its value. Imagine an popular online marketplace that only deals in a specific token and not in the dollar, there would be pressure on the token to find a somewhat stable price from within the ecosystem (even if traders on an exchange put greater pressure on the price in another direction). In some future world the use of coins within specific ecosystems could affect their value. Right now Ethereum’s Ether is used to participate in ICOs built on the Ethereum blockchain, this ecosystem affects Ether’s value to some degree.
Work: It takes a lot of work to secure the ledger and confirm transactions under the current software. It also takes a lot of work to develop the software and maintain it and update it. To the extent that the old philosophical justification for value holds (that work creates value essentially), then the work done by miners and coders to make Bitcoin work should be accounted for when determining Bitcoin’s value. MUSING: Ripple, IOTA, and Stellar have ledgers that take less work to secure than Bitcoin’s ledger. Work can help give value to something, but valuing a coin based just on hashpower is a little nonsensical (ideally less hashpower is good, as hashpower “wastes” energy). However, the work it takes to create and maintain a system makes sense to use as a justification of value (especially when we count factors like the activity of developers on a coin’s GitHub).
The Cost of Mining a Coin: Speaking to the above point, securing and recording transactions on the ledger takes work. That work has a cost (the cost of mining the cryptocurrency). The cost to mine a coin at the current difficulty should give us an idea of the rough fair market value of a coin. However, this relationship is complex. If a coin goes down in price, less miners will mine it (in theory), and difficulty will decrease. Thus one could profit mining a penny Bitcoin in 2010 and a $20k Bitcoin in 2017 in theory. So we want to stress the cost of mining a coin in the time, not just in any scenario.
NOTE: Work is the work miners, developers, and the community put into supporting the coin. However, if we just consider hashpower, we could say that no coin should trade for less than it costs to mine efficiently (never-mind if we also want to factor in the theoretically billable hours of the top tier developers who work on these things). If all else fails, the value of a Bitcoin should be at least equal to what it takes to mine a Bitcoin on average. Let’s say, for the purposes of making a point, that it costs $5k to efficiently mine a Bitcoin worth $10k. In this case Bitcoin is only valued at 2 times the cost it takes an efficient miner to mine a Bitcoin. Many stocks are valued at 30x to 50x their earnings per share, as valuations are taking into account performance over 10 years and potential increases in performance over time. Well, are we not accounting for this in cryptocurrency as well? I own Bitcoin, I own some tech stocks valued well above their EPS, in neither case do I feel like the valuations are simple, but in neither case do I feel like the value is only based on a simple factor like “because we agree it has value.” The overly simple view of Bitcoin some have, the one that ignores the utility of an updatable smart trustless global payment system, is at best not well researched and at worst is a bit condensing.
Scarcity: Another factor of basic economics that helps justify value, especially when coupled with Supply and Demand. Bitcoin, like most but not all cryptocurrencies, has value in its limited supply and the controlled pace at which new coins are issued. As demand increase, but supply doesn’t, each Bitcoin has more value. When investors truly like a coin, and thus won’t sell it, it becomes more scarce. This is reflected to some degree on the exchanges where prices increase when there are more demand than supply. MUSING: By this metric Bitcoin is clearly in the lead in terms of low supply. Bitcoin has a very low supply compared to other coins, like Ripple or Stellar or Cardano. Of course, supply is not as important as market cap with looking at the value of a cryptocurrency.
Scalability: Cryptocurrency is software, it can be updated and evolve. Another zero can be added on at the end of Bitcoin’s decimal system to increase the amount of units in circulation without affecting its supply. A software update can make Bitcoin faster and quicker. Ethereum’s coding platform can be upgraded. Faster computers and internet can make the software more efficient. Etc. Software, unlike gold, isn’t a static physical thing.
Speculation: Another factor noted above, and ultimately the primary factor, that gives Bitcoin and other cryptocurrencies their value is good old fashion speculation. From bidding wars on exchanges to futures contracts, most mediums of exchange are valued via speculation. It is easy to scoff at, but ask anyone who deals with dollar futures or gold futures on a professional level, or coffee futures, or oil futures, etc, and you’ll probably get a story of “why speculation is actually a good thing for finding prices.” The same basic logic and realities and mechanics applies to crypto. Exchanges are generally where the value of Bitcoin and other cryptocurrencies are determined. Exchanges, especially in this decentralized, young, low volume, global market are subject to manipulation and wild speculation, and thus there is some volatility in crypto prices. Still, as volume increases and adoption increases, and as people get more used to valuing cryptocurrency, it shouldn’t end up being that different from oil, gold, or a dollar in this respect. TIP: Speculation isn’t just about bidding wars. One can speculate based on factors like upcoming changes to code, potential forks (which work like user activated dividends), or potential upcoming news (good or bad). In other words, some speculation is justified and helpful, and some really isn’t. All markets have this problem. MUSING: All coins get speculated on, and this over time helps them find stable prices in theory. Some coins see rapid bubble type speculation, and that isn’t very useful, but coins like Bitcoin which are speculated on every day stand to benefit from speculation over time. Remember, most commodities are speculated on 24/7 and so are all global currencies. Again, cryptocurrency is mostly just volatile because of a lack of volume at the moment, not due to speculation alone.
NOTE: Economic bubbles occur due to speculation, but they pop (the grand and final pop) because the underlying asset lacks fundamental value. A subprime loan, weather futures, and tulip bulb futures weren’t just overvalued… they were fundamentally junk products. A subprime loan will never be repaid (its not like these loans were worth fifty sense but trading for a dollar; they were essentially worth next to nothing), weather futures were snake oil, and it turned out no one wanted a future tulip bulb. Meanwhile, the need for a global decentralized payment system (and more-so software platforms of that type with value tokens) isn’t the same sort of thin air product of those other bubbles. Not in the way ENRON’s weather futures were. Cryptocurrency is at worst like the video game bubble of 83′ or .com bubble. However, it is even more just like the stock market in general in a rapid pace. It is a bubble and bust economy with an upward trajectory as more capital enters the market and lifts up the market cap over time. The stock market is filled with companies that provide real value, and some duds, cryptocurrency is filed with cryptos that provide real value, and some duds.
Potential Market Cap and Volume Compared to the Market Cap and Volume of Other similar Assets and Industries: Cryptocurrency at this moment has about a half a trillion dollar market cap. Some of that cap is misleading due to the volatile nature of coins (a low volume coin that is pumped beyond reason essentially artificially lifts up the market cap for example). Still, compare crypto’s market cap to the market cap of bank stocks, precious metals, tech companies, etc. Or, compare crypto’s volume the volume of the FOREX markets or the market for leveraged commodities trading. When you do that you can argue that crypto has a lot of room left in it for wider adoption (and thus volume, and thus likely a larger market cap). The supply of crypto increases, but the supply of longstanding cryptos like Bitcoin and Ether substantially doesn’t. The market cap and volume compared to price over time, and how the potential market cap and volume of cryptocurrency as it becomes more widely adopted are factors that can tell us about the value of a given cryptocurrency. We can also compare market caps and volume within groups of cryptos or between one crypto and another.
Analyzing Trends: When we look at a stock or a cryptocurrency as an investor, we want to look at fundamentals first. When we look at cryptocurrency or a stock as a trader, we want to lean more toward technical indicators (like RSI, Moving Averages, and Elliot Waves). The reality is, speaking to speculation here, some in-practice value of a given cryptocurrency comes from traders analyzing past data and making bearish or bullish bets on a given crypto based on that alone. Thus past and present price and volume trends end up dictating price to some degree. With that said, the odd attempts at manipulation aside (see: pump and dumps), cryptos with fundamental value are more likely to have attractive charts and are more likely to have to volume, thus will be more likely to catch the attention of technical traders over time.
NOTE: As a cryptocurrency increases in popularity it might get listed on more exchanges. Events like this can cause some speculation and can lead to higher price and volume trends over time. Some aspects of value are in direct relation to future unknown events that naturally spark demand. Thus, when speculating on a price one has to consider events that could potentially increase the value of a crypto that haven’t occurred yet. Its a type of speculation that is somewhat justified (although in crypto this tends to be overdone and its part of what accounts for those 50%+ corrections; see: buy the rumor, sell the news). What I mean is, you can price in a future event, but if you price it in, then speculate on it, then try to price it in again upon the occurrence of the event… then the asset is destined for a correction phase (as it sheds the extra price that was priced in due to unwarranted speculation). We may not understand how to price a crypto logically, but the general wisdom of the market understands it intuitively, and thus is constantly rejecting over inflated prices.
First to Market, Familiarity, and Trust: Bitcoin being first to market gives it value. Coins like Bitcoin, Ripple, and Ethereum have earned the trust of the market over time and function as brand names. There is value in this, thus this is one of the things that gives cryptos value. TIP: Bitcoin is #1 because of this in many ways.
Word of Mouth: Speaking to the last point, cryptocurrencies that are more popular on social media are generally going to be valued higher. Again, this speaks more to speculative pricing than fundamental value, but it is a factor. TIP: Familiarity, trust, longevity and other such factors give an advantage in terms of word of mouth. Bitcoin has an advantage here as well!
We Agree it has Value: One simple stupid factor that can’t be ignored with any medium of exchange or store of value is that it has value because we agree it has value. We agree it has value based on the factors above, not for no reason. Like I noted above, it could be a conch shell. But, since we don’t live on a single island, and since instead we have the internet, it makes sense to focus consensus on tokenized, decentralized, and distributed global digital payment systems and stores of value than it does to agree on the value of conch shells as a medium of exchange.
NOTE: We can value a crypto in Bitcoin, in Ether, in U.S. dollars, in Gold, or in terms of any other asset or commodity. The U.S. dollar is always a good choice, it is stable and widely used. However, the U.S. dollar is not the only option.
Qualifiers: Qualifiers should be considered. If the current mood of the market is bearish, then that will affect the price of a coin. Right now Bitcoin is the main currency of the crypto market, if it goes down it tends to drag everything else with it. If I had a pricing system I would add a qualifier that accounted for things like “really bad news” and “bitcoin going up or down quickly”… like a Bitcoin volatility qualifier.
In other words, Bitcoin like other cryptocurrencies doesn’t just have value because we agree that it has value, or because we speculate on it, it has fundamental value (and then from there it is speculated on).
Fundamental value can first and foremost be determined by factors like fees, transaction speeds, number of transactions in a day, the cost of mining a coin over time, the quality of the code, and the activity of the community (for example of the development community). Further fundamental value can be based on its utility in terms of what its platform can do and how users can benefit and it can be based off more traditional factors of economic philosophy like all the work it took to produce a coin, scarcity and supply (current supply and potential supply of a given coin and all coins), and demand (current and potential demand for that coin and for crypto in general). Etc.
Then, with all those fundamentals considered, we can then weigh that against speculative factors like historic price and volume trends, and we can further factor in what the impact of “potential demand” and “potential updates” could have over time.
There may be speculation in cryptocurrency, but to think that values have to rely on speculation alone is a fallacy and a mistake.
How do we value a tech company when its earnings per share are in the negative but its future is promising? How do we value global payment systems and banks (commercial and central)? What is the value of a global law firm and accounting firm? How do we value a dollar? To get the value does require some speculation, but there are lots of fundamentals to consider too. It really isn’t any different in cryptocurrency, it is just a different beast (one might say: a headless/many headed beast rather than a behemoth or hydra).
A Formula for valuing a cryptocurrency? Above I didn’t offer a formula for valuing a cryptocurrency, I just laid out factors that one could use a foundation when developing a formula. My logic is this: I’m not an expert in economics, I just have a general understanding of cryptocurrency from using it and writing about it. Thus, I’m qualified to create a list of reasons it has value, but not to create a formula for how to calculate value. Further, to the extent that I could create a formula, it would likely be misleading (as the time and effort needed to create the perfect one is almost certainly best left up to someone who dedicates themselves to the task as their primary focus). That said, if I were to create one, I’d start considering fundamentals like the average cost of mining a given coin over time, supply, transactions over time, and aspects like the quality of the code and development team over time. Then I’d consider speculative factors like price trends to show both a fundamental fair price and a fair price with speculation considered (sort of like with stocks, you can calculate a fair price based on earnings and products / services alone, and/or you can calculate a fair price based on potential over time). Thus we have a formula that produces a fundamental value (which represents our base dollar value or value in Bitcoin of a crypto), then we have a formula that produces a speculative value (which can be represented as a multiplier), then we multiple the fundamental by the speculative multiplier; throw up a +/- to account for volatility over time (of the crypto and the market), and we have a value to compare against the current price. One would also want to consider expected value. Few stocks are valued based on their book value, almost all are based on value over time with expected growth factored in.
Bottomline: A coin that has been constantly popular online, has built familiarity and trust, has a history of being worked on, has an active community, has real world utility, functions as a store of value and medium of exchange, and is scalable and scarce will likely have a higher value than a coin that lacks these things in a given moment, and will almost certainly retain a higher value over time. Meanwhile the closer a coin is to its mining cost, the closer it is to the simplest version of its fair value. However, since other factors matter, one would generally expect a fair value of a good coin to be higher than its mining cost.