How Can Bitcoins Have a Fundamental Value?

Bitcoin’s Rise

Bitcoin remains the leading decentralized cryptocurrency, which has over the past decade increased interest in potential applications using its core blockchain technology. Yet, in an extremely dynamic (and often volatile) market, Bitcoin has also found its fair share of competitors—including other digital tokens like EOS, Cardano, Ripple, and Ethereum (among many others)—all of which have experienced both bull and bear runs.

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

So how can one determine what the market sees as a digital coin’s fair value, 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, but yet has appreciated in price faster than the shares of even the hottest technology stocks? These questions have befuddled investors and analysts for years when it comes to Bitcoin, with competing views on the topic.

Calculating Bitcoin Fair Value

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

Expected-Value Based

For instance, if one views Bitcoins as equivalent to stocks or bonds, pricing models appraise its expected value. Expected value is the discounted value attributed to an investment’s payoff 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 stock that does not have any current earnings or profits. Once an expected value is forecast, one can start to make estimates about Bitcoin’s current fair value.

Supply and Demand-Based

The value of a bitcoin can alternatively be approached using the principles of supply and demand. Like any other market, the market for Bitcoin achieves price discovery through the interactions of a multitude of buyers and sellers. If there is a high demand that outpaces the number of new bitcoins that are mined, this pushes up the fair price for Bitcoin.

Like many assets, there is only a limited supply of Bitcoin (21 million ever to 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 vote among shareholders or boards of directors. Thus, the price of Bitcoin is fundamentally linked to its scarcity. This makes the value of Bitcoin more akin to a collectible, such as rare baseball cards or artworks.

A different angle on supply and demand looks to stocks versus flows. A stock-to-flow ratio looks at the currently available stock circulating in the market relative to the newly flowing stock being added to circulation each year. With Bitcoin, around every four years, the number of bitcoins found in each block mined is reduced by 50%. Each halving event thus increases its stock-to-flow ratio since less new supply is created relative to the outstanding stock.

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

Network Effects

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

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

Cost of Production

One final way to consider Bitcoin’s intrinsic value is to view it as a produced commodity, 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 (in this case Bitcoin miners) are competing with one another to sell their product to consumers, this process of competition will drive down the selling price to its marginal cost.

Thus, even if demand falls short of supply, producers will be reluctant to sell below the cost of production and incur losses. From this view, Bitcoin’s price should be driven by similar dynamics.

The major 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—since it is limited to one block to be found around every ten minutes. Thus, as higher prices in the market spur new and larger miners to join the network, the number of bitcoins made remains the same. What changes is the difficulty level in mining those bitcoins. This rising difficulty maintains a steady 10-minute target between when new blocks are produced.

As a result, the marginal cost of production increases without greater supply. Recent research has shown the cost of production to predict the Bitcoin market quite well over time.

The Bottom Line

The value of Bitcoin is always changing, based on the demand for the cryptocurrency as well as the public perception of how much the coin itself is worth. It is also changing based on an ever-growing network of miners and users. As miners join the network, the difficulty for those miners also grows, increasing its cost of production.

Even if we can spot fair value, investing in cryptocurrency remains one of the most volatile investments, meaning, any potential investors must do their due diligence. However, for a chance to make a huge profit (or simply be part of the fun), knowing how to appraise the coin’s fair market value will be key.