Cryptocurrency as an investment opportunity

DeFi Consulting Switzerland

Introduction

In the first years of the cryptocurrencies life, they were suspiciously considered as a financial tool for illegal activities and a space prone to frauds.
More recently the scenario has changed: cryptocurrencies and bitcoin in particular are part of investment products offered by banks and other financial organizations, and even a significant percentage of the investment portfolios hold by personal investors on popular online trading websites includes cryptocurrencies.
This might be enough to consider Bitcoin and cryptocurrencies as an interesting investment instrument.
However, we might want to look at this issue from a more technical standpoint in order to come to more solid conclusions and understand whether the current valuations still make it a potential good investment or not.
There are a few methods that were developed in the last decade in order to properly value the cryptocurrency.

Total addressable market

A common approach consists in comparing the current capitalization with the total addressable market. As of 30 January 2021, the value of one bitcoin is 27’704,80 euros and the current supply is about 18.6 million units. That makes a capitalization of about 515 billion euros.
Bitcoin is more and more considered a store of value and, due to its nature, competes with gold as a non-sovereign store of value. At the current gold price, 1’512 euros per ounce, the total stock of gold amounts to 9.6 trillion euros.
Should bitcoin capture 10% of the gold market, each bitcoin would be worth about 46’000 euros, given the fact that the maximum number of bitcoin that will ever be available is 21 million.
Currently bitcoin captures about 5% of the value stored in gold.
However, should we consider that bitcoin attracts investments from the whole store of value market this would expand the total addressable market to tens of trillions of euros.

The equation of exchange

An additional method for the valuation of cryptocurrencies is proposed by Burniske and Tatar and it is based on the equation
MV = PQ
Where:
M = Crypto-asset market capitalization
V = Velocity: Average frequency with which a unit of the cryptoasset is spent
P = The average price of transactions executed in the period studied
Q = Number of transactions executed in the period studied
This method assumes that the value of a currency is based on the size of the market and on the velocity as it moves through the market.
While the other values can be relatively easily estimated, Velocity is hard to estimate as, even for the US dollar, it changed a lot over time. Therefore, small changes in velocity estimate can lead to very large changes in proposed valuations.

The value of crypto-assets as a network

This approach values cryptocurrencies using the “Metcalfe’s law”, a popular theory in technology and in platform economy that states that the value of a network is proportional to the square of the number of participants.
Ken Alabi showed in 2017 that this method allows to estimate the value of a cryptocurrency rather precisely. The assumption is that daily active users are an indicator for interest in the adoption of a cryptocurrency.
However, while in social networks the Metcalfe’s law applies as it is, in a financial network some important aspects are not considered, for example, not all users have the same value. Nevertheless, it makes sense to consider the number of users as an indicator of the interest in the cryptocurrency and its future trend.

Cost of production

This method defines the cryptocurrency valuation based on the cost of production. This approach was proposed in 2015 and refined in further research in the following years.
This thesis considers crypto as a commodity, which has a cost of production that influences its value.
The costs to be considered for the production of cryptocurrencies are hardware and energy cost to run the infrastructure, including cooling costs. Hence the value of bitcoin can be estimated by comparing the mining costs with the value of what is produced by the computation.
However, this approach cannot explain the high volatility that was observed along the bitcoin history and is also rather fragile as the difficulty in mining changes over time due to the fact that the mining algorithm is adapted on a 2 weeks basis.
Additionally, each cryptocurrency has different consensus mechanisms which imply different computational costs, for example in proof of stake systems there are no or very low computational costs and therefore the cost of production is much lower than in proof of work systems.

Stock-to-Flow model

The Stock-to-Flow model was first published in 2019 in the paper “Modeling Bitcoin Value with Scarcity”. The idea behind the model is that the bitcoin value is related to its scarcity and the scarcity can be measured using the Stock-to-Flow i.e. the relationship between the existing value of bitcoin and the amount of new bitcoin being produced each year.
Actually, the price of bitcoin has historically been tightly correlated with increasing scarcity shown by the stock-to-flow model.
Being the bitcoin’s stock-to-flow ratio programmatically increasing over time, this model “predicts” a perpetually rising price for the cryptocurrency.

Conclusions

Out of the 5 valuation approaches outlined above, none seems to properly model a cryptocurrency, additional research will have to be carried out in order to find a better model.
Cryptoassets are more similar to commodities or currencies but valuation frameworks for commodities and currencies are challenging. Additionally, Cryptoassets are still extremely early in their development, and we are still uncovering the utility that these assets can provide.
But if we look at bitcoin value since it was traded for the first time, we see that it has shown two characteristics: high returns and high volatility.
As the data show, bitcoin value has risen in 9 of the 11 calendar years since it was traded for the first time and has posted triple-digit or greater returns in 6 of those years. These high returns make bitcoin the best-performing investment of the past decade and probably the best-performing investment opportunity of all time.

Disclaimer

The information in this article does not constitute a solicitation to public savings and is not intended to promote any form of investment or trade, or to promote or place financial instruments or investment services. The data and information contained on this website are provided for illustrative purposes only.