After my last article on Bitcoin, I received numerous e-mails from various folks with insights about Bitcoin as an investment. Among these, the most intriguing were from those persons, including risk managers at securities firms, who are trying to get a handle on what the value of Bitcoin should be matter of fundamental analysis.
Fundamental analysis looks at a variety of factors to determine the value of an investment. The value derived from such analysis is not precise, but it does tell you the ballpark price of the investment. (Fundamental analysis is often compared to so-called technical analysis, which looks at how the investment is moving within the market.)
If you buy a stock below the intrinsic value, you’ve probably made a good investment. This doesn’t mean that the stock could not still go down, but it is much more likely that either the stock will go back up or you’ll get your money back through dividends. Conversely, if you buy a stock above the intrinsic value, then you are taking a much greater risk, since you are unlikely to get your money back through dividends but instead are betting that other factors, such as market momentum, will carry the price higher.
Again, and I can’t emphasize this enough, but fundamental analysis only gives an approximate value of what the price should be, which is important because that then tells you whether the market price is in the same ballpark (even if out in left field), as opposed to the market price not being in the same time zone, or within the orbit of Mars.
This brings us to Bitcoin: How does one determine the intrinsic value of Bitcoin by fundamental analysis? It is here that you have to realize what Bitcoin really is, which is what is known as a payment system. The Bitcoins themselves are, distilled to their essence, simply unique numbers that are kept in a safe and supposedly un-hackable ledger (this is what Blockchain mostly accomplishes). The Bitcoins are used to transfer value from one place to the next, much like an old-fashioned wire-transfer but without the intermediary clearing banks.
Or, think of it this way. In your home, you have a Star Trek-style transporter (“Beam me down, Scottie”) about the size of a microwave oven. Into this transporter, you place a plastic gift card that you’ve put $100 on, and you transport it to somebody else. They take the card, and add the $100 to their own card, and then transport your card back to you.
That is kind of how Bitcoin works, although there is no physical gift card and the transporting is done via the internet, so there is no need for a transporter.
Remember, the Bitcoin in this scenario is the plastic gift card, not the $100. So, how much is that plastic card worth exactly? The card isn’t unique, insofar as there can up to 21 million of them just for Bitcoin, and there are comparable cards in the hundreds-of-millions that are being sold by Bitcoin’s competing cryptocurrencies (or “cybercurrencies”, which I somewhat prefer).
The value of Bitcoin must then be determined by its functionality, i.e., the value of what it accomplishes. The ability to send money instantly does have some value. At the larger transaction end of things, banks charge fees for wire-transfers, and at the smaller end, credit cards companies charge fees for credit and debit card transactions. Avoiding those fees would have value.
The problem here is that Bitcoin has its own fees to maintain the ledger and verify and keep track of transactions. The Bitcoin transaction fees are typically much higher than credit card fees, and sometimes are higher than wire-transfer fees.
This isn’t to say that the underlying Blockchain technology (which maintains the ledger and verifies and records transfers) has no value; far from it. Major corporations are recognizing the value of this technology and starting to implement it themselves — there is utterly nothing that prevents a GE or IBM from developing their own payment systems for their customers and vendors based on Blockchain, and they rapidly moving to do so.
Importantly, however, when you buy Bitcoin, you are not “buying the technology” in the sense that you get the royalty rights for patents on Blockchain payment systems. If somebody else uses Blockchain, you don’t derive any money from that technology simply because you are a Bitcoin owner.
This brings us back to what Bitcoin should be worth based on fundamental analysis, and what should be the correct intrinsic value of Bitcoin. Here, you can’t count the transactions fees as a plus, because the individual Bitcoin earner doesn’t receive those fees. The Bitcoin owner instead pays those fees to those who maintain the ledgers and verify and record transactions, i.e., to an owner of Bitcoin, or to a merchant who accepts Bitcoin, those fees are a liability and not an asset.
Remembering our transporter hypothetical, with Bitcoin you are really paying for the right to use the plastic card, or a payment wallet if you want to think about it in those terms. So what is that worth?
Herein lies the problem, which is that there is not a viable pricing model that determines the intrinsic value of Bitcoin. Instead, one must analogize it to something else, and a close analogy is our plastic card. So, let’s say that you have a plastic card that can be instantly used anywhere in the world so long as you can find somebody to accept it, you own in it perpetuity, and you’ll never pay fees for the card itself (somebody will still incur the transaction charges whenever it is used).
In many ways, that is not too different from maintaining a bank account. What is a bank account worth? Let’s say a bank charges $20 per month for an account, whether it has money in it or not, or $240 per year. Let’s assume that one uses the bank account for 10 years, so that would give us a functional value of $2,400 for that period. With this analogy, if one owned Bitcoin and was going to hold and use it for 10 years, the correct value would be $2,400.
But hold on. Many banks will charge zero account fees if one keeps a minimal amount of money in the bank, something like $2,000 being common. The value in such a situation would be the time-value of the money kept in the bank, as measured by what one could get investing the money less whatever nominal (if any) interest the bank pays for you keeping your funds there. This is a very small number.
The other problem with pricing Bitcoin is that it is relatively easy for other folks to come up with competing products and charge lower fees. In fact, as more cryptocurrencies come on line — there are a paltry 1,384 of them as of this writing — there will be substantial competition to lower fees. The upshot of this is that the cryptocurrency with the lowest fees will be the most valuable, and those with high fees will effectively not have any value at all (since, if somebody were smart, they’d simply move to a payment system with lower fees).
The upshot of all this is that there isn’t a viable pricing model for Bitcoin, other than what amounts to a common-sense determination that intrinsic value is somewhere near zero.
So, why does Bitcoin have such a sky-high value today? The answer doesn’t have anything to do with fundamental analysis, and everybody to do with speculation. Folks are buying into Bitcoin solely because of what I like to call the Ghostbusters Staircase Syndrome which comes from these memorable lines in the move:
Dr. Ray Stantz: “Hey, where do these stairs go?”
Dr. Peter Venkman: “They go up.”
This is what is happening with Bitcoin now. Investors are not making anything like a fundamental analysis of how Bitcoin should be priced, but are simply looking at the market excitement around Bitcoin and the number of millionaires made so far, and coming to the shortsighted conclusion that “They go up.” This is tulip bulbs and dot-com stocks all over again.
Bitcoin is also in a sense a currency, which means that it is a medium of exchange. In fact, all currencies, whether pretty sea shells, squirrel pelts, gold coins, rai stones, and paper money, are simply mediums of exchange, which are worth exactly what somebody will give you for them. Perhaps the best explanation was given in the movie Margin Call:
“It’s just money, it’s made up, a piece of paper with some pictures on it so we don’t all kill each other trying to get something to eat.”
In this sense, the value of Bitcoin is what you can get for it. As of this writing, a single Bitcoin is worth $12,489.34 according to an exchange website. The problem for all private currencies, including Bitcoin, is that their use is not mandated by anyone, i.e., there is no built-in demand.
Compare this with government-back currencies. Those pieces of paper have little greater use in an of themselves than do the electrons that shuttle cryptocurrencies around. But there is a big, big difference.
Official currencies are used by governments to pay their employees, pensioners, for services such as government-sponsored healthcare, and for government contractors, i.e., all the dollars paid out by a government are in the official currency only. Likewise, taxes, fees, and anything else that have to be paid to the government must be in the official currency because that is all it will accept.
Private currencies do not have this innate demand, but instead are entirely at the whim of the marketplace, which means that they can be rendered extremely valuable in a speculative bubble, and made utterly worthless if the market decides to use something else as the medium of exchange. Private currencies are thus a huge gamble: They are either worth very little, or if they have substantial value then they will necessarily become extremely volatile (as with Bitcoin) because there are no assurances that they will be worth anything tomorrow.
All this feeds into the lack of a viable pricing model for Bitcoin, and in fact for all cryptocurrencies. Since it is impossible to predict that tomorrow there will be any great demand for any particular crypocurrency, the standard assumption of a set minimum future demand cannot be made.
This has dramatic implications for the investment marketplace. Since they cannot estimate what Bitcoin should be worth, and thus whether they are overvalued or undervalued, security broker-dealers, such as Merrill Lynch, cannot recommend them to clients. Similarly, banks and insurance companies cannot credit Bitcoin investments towards reserves because their long-term value cannot be estimated. Thus, the largest investors will prudently sit on the sidelines — but this drives price weakness, not strength.
None of this means that a lot of folks haven’t made a lot of money trading in Bitcoin, as there are quite a few millionaires (and a few billionaires) who have. But, at the end of the day, these were simply folks who were either extremely prescient or extremely lucky such that they were able to ride the bubble up, just like folks who invest in anything before it becomes a bubble can generate great riches. The problem, of course, is if and when the bubble goes down — riches can turn to rags very quickly. As the statement found in nearly every prospectus goes: “Past performance is no indication of future returns”.
Indeed, if there is anything like “smart money” in speculating in cryptocurrencies, which seems it is in trying to identify the next Bitcoin and get in on the ground level of that before it takes off. To this extent, investing in cryptocurrency isn’t any different from somebody trying to get in on the ground floor of the Next Big Thing, whether it is social media stocks or (once upon a time) pet rocks and tulip bulbs. Again, there is money to be made on the way up, so long as you avoid the trip back down.
This brings us to one of the sadder things about Bitcoin, which are the reports that way too many folks are trying to speculate using money they can’t afford to lose, such a from their IRAs and 401(k) plans, and even are taking cash advances against their credit cards to invest. We saw the very same thing with dot-coms in 1999 and real estate in 2006 — folks who don’t have any real idea of the risk/return ratio are borrowing their last dollar because they believe only that, as with the Ghostbuster Stairs: “They go up.”
Perhaps instead they should heed Blood, Sweat and Tears: “What goes up, must come down.”