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Bitcoin’s Fair Value Guide

The rise of Bitcoin

Bitcoin remains the leading decentralized cryptocurrency, having increased interest in potential applications over the past decade using its core blockchain technology. But in an extremely dynamic (and often volatile) market, Bitcoin has also found a host of competitors, including other digital tokens such as EOS, Cardano, Ripple, and Ethereum (among many others), all of which run both bull and bear.

Today, the market values ​​of many blockchain-based tokens are in the millions to billions of dollars, with the entire crypto ecosystem being worth more than a trillion dollars. Crypto has developed into a major economic force.

So how can one determine what the market sees as the fair value of a digital coin, or how can one arrive at a Bitcoin valuation? How do you even think of intrinsic value for something that only exists within computer networks, yet has risen in price faster than the shares of even the most popular technology stocks? These questions have puzzled investors and analysts when it comes to Bitcoin for years, with conflicting views on the subject.

Key learning points

  • Bitcoin and other cryptocurrencies have seen their market value rise incredibly over the past decade.
  • However, how to arrive at a fair or intrinsic value for a virtual token has left economists and investors confused.
  • Today, there are a handful of competing approaches to value Bitcoin and its peers, including those based on scarcity for its network effects, for its marginal cost of production.

Calculate the fair value of Bitcoin

When it comes to digital currencies, there are several methods to approach valuation. Most of these approaches differ in how one sees the nature of a digital “coin”.

Based on expected value

For example, if one views Bitcoins as equivalent to stocks or bonds, pricing models assess its expected value. Expected value is the discounted value attributed to the payoff of an investment in the future. Since Bitcoin does not pay dividends or interest, the expected value would be due to a strong belief in the underlying technology and its potential to be disruptive or even revolutionary. This would be a similar approach to valuing a start-up company or young tech stocks that currently have no revenue or earnings. Once an expected value is predicted, one can start making estimates about Bitcoin’s current fair value.

Supply and demand driven

The value of a bitcoin can also be approximated using the principles of supply and demand. Like any other market, the Bitcoin market achieves price discovery through the interactions of a large number of buyers and sellers. If there is a high demand that exceeds the number of new bitcoins being mined, it increases the fair price for Bitcoin.

Like many assets, there is only a limited supply of Bitcoin (21 million will be produced by the year 2140), but unlike other securities that have a finite supply, the new supply of Bitcoin cannot be increased by decree or shareholder vote or Board of Directors. So the price of Bitcoin is fundamentally linked to its scarcity. This makes Bitcoin’s value more like a collector’s item, such as rare baseball cards or works of art.

Another view of supply and demand looks at stocks versus flows. A stock-to-flow ratio looks at the currently available inventory circulating in the market relative to the newly flowing inventory added to circulation each year. With Bitcoin, about every four years, the number of Bitcoins found in each mined block is reduced by 50%. Thus, each halving event increases the stock-to-flow ratio as less new supply is created relative to inventory outstanding.

Since Bitcoin’s introduction, the price has followed this growing stock-to-flow ratio; each Bitcoin halving has been accompanied by a bull market leading to new all-time highs.

Network effects

If Bitcoin is viewed not as an asset, but as a network, its value may come from the size and robustness of the network itself. The term “network effects” refers to the number of users or nodes that mine a cryptocurrency.

Originally conceived to understand the value of telecommunication networks, Metcalfe’s law states that the value of a network is proportional to the number of users (or nodes) squared. While there are limitations, this perspective means that as the Bitcoin network grows, so does its value.

Cost of production

A final way to think of Bitcoin’s intrinsic value is to think of it as a manufactured good, similar to that of oil or silver. Most commodity prices are driven by their marginal cost of production, or the cost to producers to make one additional unit. Economic theory states that in a market where many producers of the same product (Bitcoin miners in this case) compete with each other to sell their product to consumers, this competitive process will reduce the selling price to the marginal cost.

So even if demand is less than supply, producers will be reluctant to sell below cost of production and incur losses. From this view, Bitcoin’s price should be driven by similar dynamics.

The big difference between Bitcoin production, and say mining ore or producing something like chairs or tables, is that an increase in demand cannot spur producers to make more Bitcoins, as it is limited to one block that is found every ten minutes. So, as higher prices in the market spur new and bigger miners to join the network, the number of bitcoins created remains the same. What changes is the difficulty in mining those bitcoins. This increasing difficulty maintains a constant goal of 10 minutes between when new blocks are produced.

As a result, the marginal cost of production rises without an increase in supply. Recent research has shown that production costs can predict the Bitcoin market quite well over time.

It comes down to

The value of Bitcoin is always changing, based on the demand for the cryptocurrency and the public perception of how much the coin itself is worth. It also changes based on an ever-expanding network of miners and users. As miners join the network, the difficulty for those miners also increases, increasing production costs.

Even if we can recognize the fair value, investing in cryptocurrency remains one of the most volatile investments, meaning potential investors should do their due diligence. However, for a chance to make a huge profit (or just be part of the fun), it is essential to know how to assess the coin’s fair market value.

Investing in cryptocurrencies and initial coin offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual’s situation is unique, a qualified professional should always be consulted before making financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.

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