Bitcoin analysis part 1: How to think about its long-term value

Bitcoin cannot be valued using traditional techniques. But it can be compared to other currencies or financial assets. Expectations are already extremely high.

This article is the first in a series analysing Bitcoin. I’ll be publishing the rest of the series over the coming week or two.

Like many people, I’m fascinated by the speculative frenzy around Bitcoin. Its price this week hit a record high above $18,500, giving the cryptocurrency a market value of more than $300bn. For Bitcoin’s proponents, the surge is evidence that it on its way to challenging established currencies like the US dollar, payment systems like PayPal, or stores of value like gold. Some Bitcoin bulls, such as John McAfee, believe that the price per Bitcoin will rise beyond $1m.

For sceptics, including Warren Buffett, Bitcoin is one of the world’s most ridiculous bubbles — on a par with Beanie Babies and the DotCom boom. Many believe that Bitcoin’s long-term value is near zero. My view is that the sceptics are very likely to be proved correct.

In this piece, I will explain the framework I use to think about the potential value of Bitcoin. The next articles in the series will then go into detail about the underlying facts and my own interpretations of what they mean for the long-term future of Bitcoin.

I should state two important things at the outset:

This series is not about the short-term outlook for the Bitcoin price. In the months ahead, it could go much higher. Or it may suddenly collapse. It is impossible to predict when it will peak.

about the short-term outlook for the Bitcoin price. In the months ahead, it could go much higher. Or it may suddenly collapse. It is impossible to predict when it will peak. This piece is not about the wider potential of blockchain technology. It is specifically about Bitcoin.

Why are people so excited about Bitcoin?

Released in 2009, Bitcoin was the world’s first “cryptocurrency”. What makes it different from traditional currencies is that it’s not controlled by any single authority or central bank. Instead, it is powered by a peer-to-peer network of its users’ computers. The entire network collectively records the transfer of bitcoins between users, using cryptography and digital signatures to verify ownership.

Bitcoin’s proponents say that its decentralised structure makes it superior to conventional forms of money. They say its benefits include privacy (because personal details are not tied to transactions), freedom from regulation, and that transactions are faster and cheaper than rival methods. We will examine whether all this is true later in the series.

At the moment, however, the reason many people are excited about Bitcoin is that its price is going up.

Putting a price on Bitcoin

Financial assets like stocks and bonds are valued by estimating the present value of their expected cash flows. Bitcoin doesn’t produce cash flows, so it cannot be valued on this basis.

To put a value on Bitcoin, its proponents first identify a large market that they expect Bitcoin to “disrupt”. Then they estimate what percentage share of that market Bitcoin could capture. From those assumptions, it is possible to work out the potential future price of each Bitcoin.

For example, those who view Bitcoin as a superior form of money compare it to the global narrow money supply, which includes all coins, banknotes and checking deposits. This totals $37 trillion. It then follows that:

If Bitcoin replaces 10% of the global money supply, the cryptocurrency’s market value would be $3.7tn.

With the maximum number of Bitcoins capped at 21m, this would value each bitcoin at $176,000.

Those who view Bitcoin as “digital gold” compare it global gold holdings, which total $7.5tn. Were people to shift 10% of their portfolios from gold into Bitcoin, the cryptocurrency would be worth $750bn, or about $35,700 per bitcoin.

Some Bitcoin promoters see even bigger potential. Chris Berniske, author of the book Cryptoassets, wrote in January that Bitcoin’s price “has enormous headroom in relation to the roughly $70tn dollars stored in global equity markets”.

Thinking about probability

It’s clear that if Bitcoin takes a meaningful share of the global market for money or gold, its price will rise. But the difficult part is estimating the likelihood of this happening.

To do so, we must examine two big assumptions that are made by Bitcoin promoters:

Assumption #1: Cryptocurrencies offer large and sustainable advantages over traditional currencies or stores of value

Assumption #2: Bitcoin is the best cryptocurrency and will remain so even as it and other cryptocurrencies evolve

As I will show in the rest of this series, Bitcoin’s advantages are far from clear — and in fact, it has numerous disadvantages. While it is theoretically possible that Bitcoin could become a widely-used currency or asset, I believe that this is an extremely unlikely scenario (i.e. the probability of Bitcoin living up to its proponents’ great expectations is virtually zero).

Cutting through the complexity

Money is a complex and controversial subject. To avoid getting lost, we need a framework within which to evaluate Bitcoin’s usefulness. The best-established definition of money is that it fulfills three core functions:

Unit of account: provides a standard measure by which the price of different items can be compared. Medium of exchange: widely accepted to intermediate the exchange of goods and services. Store of value: its price remains stable over time, allowing it to be saved for use in future transactions.

Satoshi Nakomoto, the pseudonymous founder of Bitcoin, saw it primarily as a medium of exchange — a “peer-to-peer electronic cash system”. Over time, however, many Bitcoin promoters have shifted away from Satoshi’s position and towards the idea that Bitcoin’s primary use case is as a long-term store of value — a kind of “digital gold”. As I’ll explain in the series, Bitcoin would need to fulfill all three functions if it is to become a widely-used form of money for everyday transactions.

The rest of this series will use the framework described above to analyse the potential of Bitcoin. I’ll argue that Bitcoin is innovative and does solve some problems for people who want to move money outside of the traditional financial system. But I’ll also show that Bitcoin has deep flaws that will be difficult, and in some cases impossible, to fix. Stay tuned over the next week or two for the rest of the series. I’ll post the new posts here when they’re published:

Thanks for reading! If this has sparked some thoughts or if you think I’ve got something wrong, please let me know in the comments below.