Two ways to value bitcoin

The price of bitcoin has surged sharply since the beginning of the year, having increased almost fivefold from its 2022 lows. How high can the price go? In this article, we attempt to answer this question using two very distinct valuation models

Alternative currencies

Almost one hundred years ago, Henry Ford, the man behind the Ford Motor Company, imagined an “energy currency”, suggesting that instead of gold, nations could base their currencies on energy resources. While this idea never materialised – probably due to its potential to undermine government control over wealth- Ford’s concept is partly reflected in bitcoin.

This cryptocurrency, often referred to as digital gold, operates on a decentralised network and is created via a “mining” process that requires a significant amount of energy. Indeed, some argue that the value of bitcoin is intrinsically linked to the energy expended in its creation.

Capriole Investments developed the “Energy Value Equivalence” model, which calculates the value of bitcoin based on its energy consumption. According to this model, bitcoin’s intrinsic value is higher than its current price.

Another valuation model for bitcoin is the “stock-to-flow” ratio, which assesses its scarcity by comparing existing supply with annual production. This model has attracted considerable interest for its ability to accurately predict bitcoin’s price movements.

The two above models offer distinct but complementary perspectives, highlighting the dynamics driving bitcoin’s appreciation.

The energy value model

In 2019, Capriole Investments developed an interesting model known as the Energy Value Equivalence, focusing on the energy expended in bitcoin’s production. At its core, this model seeks to assess the intrinsic value of bitcoin by quantifying the energy expended in its production and compare it to the energy required to produce other assets or commodities.

The model highlights several key insights: firstly, that energy, measured in raw Joules, is a fundamental determinant of bitcoin’s fair value. Secondly, increased energy input corresponds to a higher fair value for bitcoin. Moreover, the Energy Value model suggests that bitcoin’s price tends to revert to its mean Energy Value over time.

The assumption underlining the model suggests that bitcoin’s intrinsic value is a function of the amount of energy expended in its production, the rate at which its supply grows, and a conversion factor to fiat currency for energy expenditure.

All units cancelling out, the equation suggests that the fair value of bitcoin (V) is a function of the Joules of energy spent to produce it. On this basis, Capriole Investments built a statistical model on daily data from January 2010 to 2019. The resulting R-squared of the model in relation to the actual bitcoin price of 80%, the higher the R-squared, the more reliable the model. According to the Energy Value model, bitcoin’s intrinsic value currently stands close to $81,000.

Stock-to-flow model

Also in 2019, Plan B, a mysterious Dutch institutional investor, presented the Stock-to-Flow (S2F) model assessing the value of bitcoin with surprising accuracy. This quantitative model attempts to predict the theoretical value of bitcoin over time based on asset scarcity. Initially greeted with scepticism, in 1999 the model predicted a rapid rise in bitcoin to $55,000 after the May 2020 “halving”. A prediction that proved accurate, as bitcoin reached this level in 2021, reinforcing its credibility through its ability to predict prices.

In simple terms, the “Stock-to-Flow” model is an indicator of the scarcity (or abundance) of a commodity. It is the total amount of a resource’s reserves (the “stock”) divided by its annual production (the “flow”). The Stock/Flow ratio therefore measures the annual marginal supply, or additional supply, in relation to existing reserves. The higher this ratio, the less supply is renewed, and therefore the more the asset in question can be considered “scarce”.

This model is generally applied to precious metals, such as gold. Current gold reserves (the “Stock”) are estimated at around 192,000 tonnes. The “Flow” corresponds to the quantity of gold extracted each year, i.e., 3,200 tonnes. Dividing the total supply by the “Flow” gives a ratio of ~60. This means that, at current production rates, it would take around 60 years to extract 192,000 tonnes of gold.

Given bitcoin’s unique properties (e.g., time-limited supply), the stock-flow model seems to apply to bitcoin in the same way as it does to precious metals. Bitcoin currently has a “stock” of around 19.6 million and a “flow” of 0.353 million per year, giving a SF of 55.5. Before the May 2020 “halving”, the SF was 25 (the SF was even lower a few years earlier). In the future, bitcoin’s SF should continue to rise, influenced by its limited supply and the halvings every 4 years. The SF is predicted to be 110 after the April 2024 halving.

The statistical model built on gold, silver and bitcoin revealed a strong correlation between SF and asset value, with a 95% coefficient of determination. This suggests that as scarcity increases, so does asset value

To estimate the price of Bitcoin, the model suggests using the 365-day average of the SF ratio. The stock-to-flow model has an R-squared of 88% on the same data used in the energy value model. The current model price currently stands close to $100,000.

Model limitations

While the Stock-to-Flow and Energy Value models offer valuable insights into Bitcoin’s value, it’s essential to recognize their limitations. These models, emphasising scarcity and energy consumption, may overlook critical factors such as regulatory risks and market volatility. Bitcoin’s relatively short history may raise questions about the long-term validity of these models.

In extreme scenarios where all bitcoin miners cease operations, which could occur due to a catastrophic event, the Stock-to-Flow model predicts an infinite bitcoin price, while the Energy Value model predicts zero value, highlighting the complexity of bitcoin’s valuation dynamics.

Nevertheless, the Stock-to-Flow and Energy value models offer valuable insights into bitcoin’s evolving value proposition and remain prominent tools for understanding its price dynamics in the cryptocurrency market.

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