It is easy to find an arbitrary opinion on the supposedly reasonable price of bitcoin on the Internet. Determining a justifiable value for the cryptoasset is much more difficult.
For technically oriented investors, the valuation of an asset is irrelevant, because they only pay attention to the price trend and its fluctuation range. However, most institutional investors also use fundamental metrics, if only as a supporting argument for an allocation.
There are several ways to value a cryptoasset. In the simplest case, a token generates cash flows and, as with conventional assets, discounted cash flows can be used. For other digital assets, more complex approaches such as the network effect or purely statistical approaches can be used. In practice, different methods are usually combined.
“Price is what you pay. Value is what you get.”
The Scarcity Factor
In the case of Bitcoin, the data history is short, but due to the recognizable parallels to gold, analysts also look at the scarcity factor when evaluating the first cryptoasset. The relevant data is available to anyone interested, because in addition to the final money supply, both the number of existing coins and the number of newly issued coins are known at all times.
There are currently around 19 million Bitcoin. Similar to the share certificates of a corporation, not all Bitcoin are in free float and are traded regularly. Another factor is those Bitcoin that are lost forever, the so-called lost coins. These permanently reduce the supply and are thus a deflationary factor that supports the value of the remaining coins.
Statements about the holding period can also be included in the valuation. For example, existing Bitcoin can be categorized according to the duration for which they are associated with a particular address. In this way, the share of long-term investors who are not interested in the daily noise of the market can be determined.
"If you don't bet, you can't win. If you lose all your chips, you can't bet."
The Stock-to-Flow Model
The elements of the Bitcoin protocol, such as cryptography, proof-of-work, and dynamic difficulty adjustment, have one goal: verifiable scarcity of a digital good. There are many cryptoassets that use the protocol to preclude arbitrary proliferation of existing tokens and to determine the expansion of the money supply and any caps.
The limited number of certain tokens and the transparent scope of money creation led to the well-known analogy of Bitcoin as digital gold. As with the precious metal, therefore, the quite controversial concept of "stock-to-flow" (S2F) was quickly applied to Bitcoin. In this approach, the stock and the newly created coins (flow) are put into relation. The result, the stock-to-flow ratio is used by some analysts as a basis for valuing bitcoin and other digital assets.
Since both the number of existing Bitcoin and the timing and number of new coins are known, the value of the stock-to-flow can be determined for any point in time in the past and in the future and accurately.
“Apple is a mobile network, Google is a search network, Facebook is a social network, Bitcoin is a monetary network. All benefit from advances in software & hardware technology, as well as Metcalfe’s law. Many understand the former, few understand the latter.”
When considering crypoassets as a store of value, comparisons can also be made with other asset classes. What is striking in all discussions about the market value of individual assets, be it Amazon stock, a painting by Rembrandt, or bitcoin, is how many underestimate the size of the global capital market and overestimate the share of cryptoassets.
In relation to the total value of all stocks, bonds, real estate, as well as the art market and all gold holdings, the market value of all cryptoassets represents less than one percent.
“Uncertainty is an uncomfortable position. But certainty is an absurd one.”
Network Effect & Metcalfe's Law
The network effect was popularized by the work of Robert Metcalfe, one of the co-inventors of Ethernet and co-founder of network equipment manufacturer 3Com Corporation. The network effect describes how the utility, and therefore the potential value, of a network changes as a function of the number of subscribers. As with a telephone network, the utility of any network grows with the number of active users. Adoption by many users is essential, especially for a decentralized payment system. Metcalfe formulated a formula for valuing networks that is now known as Metcalfe's Law.
When valuing bitcoin based on the network effect, the number of active addresses is usually used as an approximation for the number of users. The reduction to this one factor makes the evaluation very simple, but due to the only rough approximation it is prone to errors. Models used in practice therefore integrate other parameters such as the average transaction volume per address.
Metcalfe's Law can be an interesting building block within more comprehensive evaluation approaches. The theoretical background is much better founded than for the stock-to-flow model, but there is no shortage of well-founded criticism of this approach either.
"Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted."
Cash Flows & Multiples
One of the main criticisms of cryptoassets is the lack of capital gains. This general criticism is misguided because, while it applies to many cryptoassets such as bitcoin, it is by no means true of all of them. Especially in the world of Decentralized Finance tokens exist that generate cash flows. Therefore, in contrast to Bitcoin, established approaches to company valuation can also be used when valuing these projects.
The discounted cash flow (DCF) method is the best-known type of earnings-based valuation. The approach is simple and easy to follow. Another approach is to use conventional valuation ratios such as sales and profits in relation to market value. This approach is also called Comparable Company Approach and can easily be applied to tokens of a sector. For example, projects in a sector such as decentralized exchanges (DEXes) can be directly compared with each other.
“The markets are the same now as they were five to ten years ago because they keep changing – just like they did then.”