Bitcoin Series 22: Bitcoin Valuation for Dummies

 A market in Tengeru, Tanzania.  Source:  Wikimedia commons

A market in Tengeru, Tanzania.  Source: Wikimedia commons

[updated: Some people apparently not familiar with the "For Dummies" reference - it was/is a popular series of reference books in the US - not pejorative. :) ]

Sorry to disappoint both bulls and bears but there will be no price targets here, just the theory about when and why bitcoin has a non-zero price.

Three steps to a bitcoin price:

1.  Imagine any usage case (international peer-to-peer remittances, micropayments, machine-to-machine transactions, holding some value outside of the existing financial system, etc) where BTC turns out to be useful.   It does not matter what the usage cases are at this stage - for the basic analysis to hold there just has to be at least one usage case that sticks.  

2.  Please note that (a) you need bitcoins to engage in these usage cases, (b) you don't have any bitcoins, (c) other people do have bitcoins and (d) the supply of bitcoins is mathematically limited.

Moreover:  If an application works in bitcoin, the fact that you own, say, litecoins or dogecoins is not necessarily helpful because most apps will support 1 or 2 'coins' at most.   So competition between alt-coins has very little do with minor differences in their implementation algorithms, but with how many applications are built on top of each one.   Though this could change, bitcoin has a tremendous head start in this regard.

3.  Given #2, you need to go buy bitcoins from others.   At this point, we have a buyer, a seller and market and, since there is no holding cost to a BTC, a price definitionally above $0.00.

Three basic conclusions:

4. The only thing that matters to BTC's valuation is how many real-world usage cases emerge for BTC.   If there are dozens, it will fulfill the dreams of its evangelists.   Conversely, the bear/ponzi case that value is $0, is another way of saying "there is no context anywhere on the planet that BTC will be useful" because there is no other scenario in which price hits $0.

5. Bitcoin is an open system so every developer/VC on the planet has the economic incentive and ability to discover real-world usage cases for it.

6. To conclude that the current financial and payments system (that still has us using plastic credit cards and banking phone apps that *have us take pictures of a paper check* to deposit it) has exhausted all financial innovation possibilities for our online, robotic software-eats-the-world of 2025 is a profound lack of imagination, in my humble opinion.

Unknowns

Of course, there are many unknowns in the above:

7.  If and when the usage cases will develop

8.  If they will be hindered by governmental regulation and competitive lobbying from the current payment processors 

9.  If superior forms of bitcoin will emerge.   One form that might be theoretically better (but a long way from being imminent) would be a FedCoin.

Bulls and Bears
In the context of the above, you can see why very smart people have such wildly divergent reactions to bitcoin:

10.  If you are a traditional consumer financial services executive (or reporter) where innovation has been measured over the scale of decades, a new currency that seems a bit shadowy, risky, volatile, and not clearly cheaper to use for domestic transactions sounds like a loser.

And so the fact that this loser thing has a $5-$10B 'market capitalization' or 'money supply,' sounds like the very essence of mass delusion and a 'bubble'.   Someone, somewhere must be tricking someone with a ponzi scheme for this to be happening!

One might kindly argue to you that this view is too focused on a specific point in time (today!) rather than the rate of change.

11. If you are VC/developer/futurist whose business is focused on successfully extrapolating trend lines, then bitcoin looks exactly like the type of thing that leads to epic riches: 

(a) It has an extraordinary rate of growth on every dimension - in four years, it has gone from a 'white paper' for the love of god to millions of users and better-than-price-competitive merchant processing (even with volatility hedged out) than merchant processing platforms that have taken decades to built.  

(b) It is an open protocol with no central point of failure.  Protocols of this type have historically been huge wins in technology because they foster innovation that was completely unimaginable to their inventors (aka TCP/IP).

(c) It is completely consistent with general tech trends - more economic activity is moving to online, machine intermediated, global and decentralized modes of delivery.   Bitcoin and the like are very well suited to that environment.

So, to a tech brain, the concept that bitcoin or other cryptocurrencies might facilitate 1% of global transactions in 2025, including whole classes of transactions that don't exist today like machine-to-machine payments, seems perfectly plausible.    In that model, bitcoin today is vastly undervalued.

Summary

Most of the online discussion about the valuation of bitcoin is misguided.   If you are using any of these phrases in your argument, you are doing it wrong:  "ponzi scheme", "the evils of paper fiat currency," "did the price move today?," "going to the moon,"  "is bitcoin dead?" 

Bears of the 'going to $0' variety should make the case that 'BTC will have no applications' and that the current system will fill in the gaps just fine.   That is a pretty confident statement...and usually an intellectually lazy statement.

Bears of the 'going to $50' variety should explain their thought process about what applications they are assuming, what market share gains they are assuming and so on.     

Bulls of the 'going to $50,000' variety should making a case about exactly what applications of the financial system BTC will be able to take over and be better than the current system (on a fully loaded cost basis, including consumer friendliness, security, etc).

And even when all that is done, you will realize that a large part, if not the majority of bitcoin's current valuation, is based on 'potential applications that have not yet fully developed' as opposed to 'activity occurring today.'

In this regard, it trades exactly like any mid-stage VC-backed company that has super-duper growth rates, with the difference that you are making a bet that 'someone, somewhere will invent good usage cases' as opposed to betting on a single management team (this is deeply underappreciated).   In other words, the currency is, in some ways, an ETF on the entire field.

Disclaimer

And because people are silly, our usual disclaimer applies:

(1) We do not care if you buy bitcoins (2) We are not a broker-dealer, broker, financial advisor or licensed in any way to give you financial advice (3) This is most certainly not a recommendation to buy, sell, short, trade bitcoinslitecoinsbbqcoins or StalwartBucks – you could lose all your money in one of many ways including, but not limited to: your incompetence, poor security, poor backups, software bugs, counterparty risk, exchange rate risk, liquidity risk , regulatory risk,  and more! You are 100% buying bitcoins at your own risk and on your own initiative. (4) Bitcoins are not anonymous and exchanges and online wallets even less so.   If you are going to use bitcoins to try to cheat on your taxes / divorce settlement / child support, you are a moron. (5) These are not the only ways to buy bitcoins (just some of the more popular ones) nor are we endorsing these companies – any of them theoretically could be hacked, run away with your money or be shut down by regulators / coopted by the ‘system’. (4) Ledra Capital, our affiliates and our principals might hold any number of old-timey or digital currencies at any time long, short or falling out of our wallet all crumpled up after a long night of drinking.   If we knew how they would trade against each other in the future, we would be having umbrella drinks on our private islands, not tweeting about bitcoin.

For the full bitcoin series: ledracapital.com/bitcoin 

Twitter: @polemitis and @ledracapital
Facebook: www.facebook.com/ledracapital
Ledra Bitcoin Digest email newsletter: ledracapital.com/subscribe

Posted on March 1, 2014 and filed under Bitcoin.