After seeing claims of Bitcoin bubble or revolution trending across the web, I did some simple math to provide a rough valuation framework. Full disclosure: I own bitcoins.
Bottom line, I get ~$3,500 per bitcoin by assuming Bitcoin receives 1% of speculative capital earmarked for similar assets (note: I’m missing a few pools of capital in this analysis, which would increase the price). The math is fairly simple, price = $s invested / # of bitcoins in circulation, but determining the numerator and denominator is the trick.
Before diving into the details below, let’s step back to examine higher level assumptions. The main premise is that Bitcoin’s appeal as a speculative asset is tied to its adoption as a better way to send value. By better, I mean (i) low transaction fees which unlock use cases such as micro-payments and remittances, and (ii) a programmable script that enables the development of payment and verification applications (e.g., automated escrow, dividends, etc.) without the permission of existing bank networks. For Bitcoin to handle additional transaction pools, for example US online retail sales of $262B, the total value of bitcoins outstanding (currently ~$10 billion) would need to increase. So in the optimistic case, speculation (recently fueled by positive press) increases Bitcoin’s total value/market cap, which likely drives adoption through increased liquidity, which fuels further speculation.
Supply (# of bitcoins)
For the denominator of our price equation (easy part), there are roughly 12.0 million bitcoins currently outstanding. I then added the number of bitcoins mined in the last year (~1.5mm) to arrive at ~13.5 million bitcoins so that we have a forward looking number. I believe this to be conservative for 2014 given that mining becomes more difficult with time, implying less bitcoins will be mined in the next year.
But, per Fred Wilson, won’t the increasing number of merchants accepting bitcoins create more supply? (as merchants sell bitcoins earned to lock in dollar/other currency revenues)
I humbly disagree because a consumer and merchant transacting through bitcoin theoretically offset each other. For example, if I hire programmers in Europe and pay them with bitcoins, my understanding is that I have to buy bitcoins before sending these bitcoins to the programmers. The programmers can then either sell the bitcoins to lock in their wage or store the bitcoins if they wish to speculate. Either way I had to buy bitcoins at some point before the merchant sold them (or kept them).
Some commentators define demand as a percentage of general economic quantities such as gold or GDP, which may make sense. However, I believe a more conservative metric is the amount of speculation capital potentially allocated to Bitcoin. Thus, I tried to conservatively estimate the value contained in the following vehicles, and the typical asset allocations these vehicles make for cash, commodities and “other” investments:
- Five Leading US Online Brokerages: Included all customer assets because the individual investor decides, no asset allocation
- Global Private Wealth Management: ~6.6% allocated to commodities, cash or “other” (non-private equity/VC) based on Barron’s pole
- US/UK Endowments: 5% allocated to “other/cash” based on NACUBO study
- Sovereign Wealth Funds: 11% allocated to “cash” using NZ/AUS numbers reported by SWF Institute as proxy (other countries behind a paywall)
- Pension Funds: 1% allocated to cash per Towers Watson study
- US Insurance Company Investment Assets: 4% allocated to cash based on NAIC report
If you multiply those allocations by above vehicles’ assets and sum (excel screenshot here), you get ~$4.7 trillion that is appropriate for bitcoin purchase.
Bringing it all together, if 1% of Bitcoin appropriate dollars are invested in Bitcoin, then price = $3,508.59 = 1% of $4.7 trillion / 13.5 million bitcoins
Of course there are risks to the Bitcoin system and therefore its price, as outlined here (scroll down to list at the end), but I think those risks are not in excess to potential returns (and some of them are mitigated by network effects).