SINGAPORE (Apr 30): Does anyone remember Bitcoin? You know, the investment opportunity that just six months ago had everyone talking as its price shot up from US$4,395 on Oct 1, 2017 to a high of US$19,343 on Dec 16, 2017 (see Chart 1). Investors quadrupled their money in less than three months, and those who had held on to their Bitcoin from the early days experienced mind-boggling returns. Tales of newly minted Bitcoin billionaires created a veritable gold rush as investors piled into the digital currency hoping to strike it rich.
You know how the story has played out since then — Bitcoin prices have plunged as regulators, alarmed by the surge of interest in unregulated cryptocurrencies, clamped down. As at April 17, one Bitcoin was worth only about US$7,890, according to Coindesk, 40% of what it was at its peak. Investor interest has accordingly subsided.
Easy come easy go, you might say, especially if you were wise or lucky enough to have avoided the Bitcoin mania last year. Yet blockchain — the innovation underlying Bitcoin — is not going away. One might argue that the crash simply represents an awkward phase in the maturity of Bitcoin and of cryptocurrencies in general, like a teenager experiencing a growth spurt. As the speculative fever dies down, it starts to become slightly more reasonable to ask: Is it possible to come to a valuation (or at least a valuation methodology) for Bitcoin? As investors, could this help us decide when it is a good time to buy or sell the cryptocurrency?
To begin, let me clarify what I mean by valuation and valuation methodology. A valuation methodology is a way to help us decide what something is intrinsically worth. For example, people generally agree on the methodology for valuing shares in a company — simply add up all future expected cash flows from the company discounted by the time value of money. There might be disagreement on discount rates and on what the future cash flows might be, and so every investor may come to a different valuation, but the valuation methodology itself is well established.
The problem is that Bitcoin cannot be valued the same way, because it does not generate cash flows. Neither can it be valued like commodities, using supply and demand curves, because a Bitcoin has no intrinsic value (it is just a series of numbers, unlike oil or wheat or orange juice). Even as a currency, it is difficult to discuss Bitcoin valuation because Bitcoin is not used by a single identifiable economic entity and so currency valuation concepts such as purchasing power parity and terms of trade cannot be directly applied. This, in part, is why Bitcoin prices have been so volatile — because nobody can really agree on how much it should be worth.
Despite these difficulties, we do have clues on how Bitcoin valuation may be reasonably discussed. Aswath Damodaran, a Harvard University professor well known for his work on valuation methodologies, argues that Bitcoin is best treated as a currency, but not a good one yet. On the one hand, Bitcoin clearly has some value as a currency because it provides an anonymous and decentralised way to pay for goods and services. On the other, as Damodaran points out in his October 2017 article “The Bitcoin Boom: Asset, Currency, Commodity or Collectible”, Bitcoin performs poorly as a medium of exchange because of limited adoption, and is a poor store of value due to its volatility. Bitcoin’s long-term price level will therefore depend on how widely it is adopted in future.
Others have tried to estimate what this price level might be. Dan Davies, a senior research adviser at Frontline Analysts, suggests that Bitcoin might be valued using the Quantity Theory of Money, a basic observation in economic theory that the amount of money spent in a closed economy is equal to the value of transactions within that economy. This implies that Bitcoin price is determined by the value of Bitcoin transactions worldwide divided by the amount of Bitcoin in circulation and how fast it changes hands (see his September 2017 article “How I guesstimated the value of Bitcoin in 2014” for an excellent exposition). Since the number of Bitcoins is limited by design to about 21 million, Bitcoin’s value in future should therefore be proportional, in the long run, to the value of transactions that are conducted in cryptocurrency (which is, of course, subject to massive uncertainty, but at least provides a way to get to a valuation that is correct within orders of magnitude).
There are many other variations to this basic line of argument; some have tried to anchor Bitcoin’s value on money-laundering transactions alone, or a modified “price-earnings” ratio based on transaction volume. But the common theme among these competing methodologies is the agreement that in the long term, Bitcoin’s valuation is intimately tied to the extent of its adoption as an alternative currency, which in turn depends on how good it is as a medium of exchange and a store of value.
The problem for Bitcoin investors is that adoption runs counter to the speculative use of Bitcoin. Investors want to see the prices rise quickly, but the more they spike in the short term, the less viable Bitcoin is as a currency in the long term. When Bitcoin prices rise, people become reluctant to spend it, anticipating that it will be worth even more in future. Even more problematically, Bitcoin volatility makes it difficult for companies to accept Bitcoin as payment because they would need to adjust their Bitcoin-equivalent prices constantly to maintain consistency with real-world currency prices.
What all this suggests is that if you are buying Bitcoin mainly as a speculative investment, long-term valuation is probably not a useful approach. It is futile at this stage to predict the extent of Bitcoin adoption, especially given its self-defeating nature and also the existence of competitor cryptocurrencies. It is much better to ride the short-term price spikes and get out while the going is good. Personally, unless you are a star trader, I would stick to investing in equities — you will not get eye-popping returns but at least you can be pretty sure they will go up in the long run. Slow and steady wins the race.
Herbert Lian is a financial advisory representative at IPP Financial Advisers Pte Ltd. The views expressed here are solely those of the author in his private capacity. This article should not be regarded as professional investment advice or as a recommendation regarding any particular investment.
