A Valuation Framework for Bitcoin

There is no new thing under the sun.

– The Bible

Disclosure first: This piece might be sacrilegious to many value investors. In Nov 2013 (yes, the last Bitcoin “bubble”), I put a small percent of my net worth then into Bitcoin. I have been holding and plan to hold them until it reaches my estimated value (showed below). Please do NOT see this piece as a defense to Bitcoin critics or as investment advices (In fact, I am always ready to change my view, however I just didn’t come across convincing counter-arguments. Or put it differently, I’ve been most of the critics’ place and held similar suspicion before but changed later). I see this piece as an alternative thinking framework to a potential significant invention in human history, and I welcome any sort of comments/feedbacks/critiques.

A few lemmas I want to establish before going further:

  1. The universe we live in consists of two and only two elements: energy and information. (mass, or material, could be unified to energy by Einstein’s famous equation: E = MC^2)
  2. Bitcoin’s value is binary (i.e. it should either 0 or something very large, there is no middle ground)
  3. If “intrinsic value” is defined as “present value of expected cash flow from a value producing asset”, Bitcoin (as well as all kinds of money) has NO intrinsic value.
  4. Global governments as a whole, is not as prudent and resposible as developed counties’.
  5. I have been wrong and could be wrong on Bitcoin

What is money?

In the essence, money is a claim (bond) on debt of energy and information (E&I, hereinafter), however it’s designed to be repaid by any others in the system (rather than by the debtor). Why it is true? Let’s try following thought experiment (TE, hereinafter)

TE1: For as long as human’s existence, its activity can be generalized as “exchange of E&I for all 5 level of Maslow’s needs”. Now let’s take a snapshot of any second in human history (the reason for second is I want to simplify the model the most so we don’t need to worry about the speed of money for now), one part of the human transfer the ownership of certain amount of E&I to the other part, and that’s the creation of the debt. In barter age, some of these debts can cancel each other, however for the most part of human civilization that is not so anymore, thus some token was needed to record these debts and that’s is when money came to the stage. The form of token has evolved from shells, to metals and to fiat, with the primary direction of “to record E&I debts as accurate and convenient as possible” (side note: I think fiat is a great human invention, as it creates a new function – gauging debt creation activity, in addition to the traditional debt recording, whole different topic though).

Now the most important part of this experiment arises: this E&I debt doesn’t necessarily need to be repaid by the debtor, however it was by designed to be repaid by others. So how can the holders of claims on E&I debt ensure a different person than the debtor fulfill such an obligation? No matter how you try to cut it, I think it will come down to one word: Trust. Historically, the trust was instilled either by tribal convention, religion, or government (with the last one most familiar to modern human). I would argue that Bitcoin (along with blockchain) created a new way of instilling trust to human civilization, which is by math (in the most fundamental form, as the whole information technology is a form/application of math).

More consideration of money

If you find agreeing with what I said thus far, here are some additional relevant consideration about money before we can start valuing it.

– Quality of money

When human have multiple choices to record E&I debt (silver & gold in history), how do they decide which one to use? I would borrow Gresham’s law – “Bad money drives out good.”, but make some changes in terms of the good/bad definition. Simply put, good money has better traits for debt recording accuracy and higher future expected E&I debt per unit than bad one. That is why gold is better than silver in a period of history, and fiat is the worst one in terms of future expected E&I debt per unit perspective (also partially why the entire E&I exchange nowadays is recorded in fiat).

What I expect, based on this assumption, is that a blockchain based token (not saying it’s Bitcoin for now) to become the “best” money as it has the best traits for debt recording accuracy and highest future expected E&I debt per unit than all other traditional money. Similarly, I do not expect this coin will be used in circulation once it reaches an equilibrium, similarly to gold nowadays.

– Difference between money and value-generating assets

Traditional value investing purely focuses on the discounted cash flow part of a value-generating assets, and see the perception of such assets by general public as noises around the intrinsic value which they could exploit (in long term, the noise is mean reverting and should be 0). This is a great metal model and I personally believe the long-term viability of such practices. The problem to apply that metal model valuing a money is that it fails to recognize the existence of a type of asset whose value will be solely depending on the perception of the adopters (or the trust one could claim E&I debts from anyone in the system). Furthermore, the perception in this case is not mean reverting until it reaches an equilibrium, thus such an asset should have a non-zero value. For this point, just mentally draw a gold price line from the initial discovery in human history to today, it should be something like first upside then plateau.

My point is that we may be in the upside part of that line for a blockchain based money, and I also agree that once it reaches the plateau, it would become a mediocre investment just as gold did in the past century or so.

– All debts are recorded in fiat now, why does other type of money (gold, etc.) still has value?

That is true almost all E&I debts are initially recorded in fiat nowadays, however other types of money still perform the function of recording E&I debts, just in secondary level (from fiat) and for legitimate reasons.

TE2: Certain portion of human would own much more E&I debts claims than they can consume, and they could choose to record these debts in any forms of money. If these human is in a dictatorship regime (where confiscation or nationalization is possible), they highly possibly would choose to store claims on debts in non-fiat form (and large portion of these debt claims into good money, then translate back to other forms if they can flee to safer regime). The same holds true for imprudent monetary policy regime or war regime, etc. If these human is not subject to chaos and live in a society like US, they would still choose to store majority of these claims in non-fiat form (maybe more in value generating assets like stocks/bonds/real estates than in good money, but still there are certain percent in good money).

My point is that there will be always certain percent of human E&I debts stored in the form of good money.

How to value good money?

Now let’s do the fun valuation part. To start form a simplest model, let’s try this thought experiment.

TE3: Jesus coin

Suppose when Jesus created Christianity, there was this coin had exact features of Bitcoin (21m in total, counter-fake, not-manipulable etc.) and Jesus instructed anyone believe in him to store x% of their E&I debts in this form (call it Jesus coin). We also assume his believers will follow it strictly. So how do you value this money? Simply, get the total E&I debts in the Christianity community at any point of time, multiple by x% then divide by 21 million. One thing I want to introduce here is a new unit for the E&I debts (as using fiat as unit is subject to fiat’s value changes), let’s just call it “J” and it should be an absolute and universal term (similar as Joule for energy). Then also try to mentally draw such a price chart from the establishment of the religion to now, it should be much alike the gold price chart we tried before.

In essence, Bitcoin is no different than this Jesus coin metaphor. I would use the same framework to value it: 1) Estimate the size of the Bitcoin believer community (denote as B), 2) Estimate the total E&I debts in this community (denote as J), 3) Make an assumption of X% of the E&I debts they are willing to store in Bitcoin, 4) Use the same formula to get the value and 5) most importantly, estimate the probability (denote as S) Bitcoin will fail to be trusted as such a good money (The Jesus Coin had 0% because I assume full trust of the believers).

So here you have it, Bitcoin’s market cap = B*J*X%*(1-S)

Unfortunately, this is only the easy part, the hard part is to make these estimates, and that’s why many well-respected investors and technologists in their own fields disagree with each other on these parameters.

I could throw in my estimates just for play around purpose: Gold, as much as despised by some as a comparison, is a good comparable to me (just so I could estimate B, J & X at once). On one hand, I don’t think gold will be 0 just because Bitcoin is created, but certainly there could be some defection from gold to Bitcoin. On the other hand, there is this new group of Bitcoin adopters who never put part of their E&I claims in gold form. I would just throw maybe 30% of E&I claims now in gold will be in Bitcoin when it reaches the equilibrium (the plateau part). So B*J*X% = gold market cap * 30% = 7 trillion $ * 30% = 2.1 trillion $ (here we assume J to $ translation rate is the same for both gold and Bitcoin), implying $100,000 per Bitcoin if S = 0. Now I would throw again my estimate of S is 5%, which imply a Bitcoin worth 95,000 today’s $ to me. Note that, if the J to $ translation rate changes in the future (presumably in an increasing direction), it could worth more in future’s $.

Risks

I think majority of the disagreement between two sides are on S, the trust level of Bitcoin as a good money. Following are some common bear cases arguing for a higher S value (or 100% to the extreme), which I don’t necessarily agree with.

Competition – how can Bitcoin stay as “the” good money when anyone can create an alter coin having the same features? That’s a fair point, and I agree that it may not be the current Bitcoin it is. But my conviction is it will be from the genesis blockchain network (either the Bitcoin, or some mutated fork of Bitcoin). Why? The same as why gold became the good money in old time, the same as why QWERTY keyboard became standard, also the same as .com domain is much more valuable than all other domains. First comer advantage. When we are dealing trust/perception, we should also realize the stickiness of a perception/ideology/religion is tremendous. A virtuous feedback loop runs: the more adopters make it better money (higher the future expected E&I debt claim per unit), the better money attracts more adopters.  Thinking historically, if Christian was able to spread over to the Arab world before Muhammad, there might not be Islam at all. Bitcoin to me is already spreading all over the world now. Unless there is a fundamental malfunction of the Bitcoin Blockchain network (very low probability as it was tested by the smartest technologists for almost 10 years), this perception is very hard to reverse or alter. One good feature of Bitcoin is that original Bitcoin holders (anyone who own Bitcoin before 8/1/2017 when the first hard fork happened) will have the same amount of coin of any mutated coin, so fork is also not a concern. That’s why I think competition (within or without the network) is not as important factor to evaluating S. Only Bitcoin itself (its undiscovered fundamental flaw) can destroy Bitcoin.

Technological Breakthrough – What if in the future there is new technology could break the corner stone of Bitcoin Blockchain (say SHA-256 algorithm)? I agree that is a legit concern, however on the other hand, we have to admit Bitcoin Blockchain itself is an evolving organism. So, either a mutated version immune to new technological threat will emerge or the genesis one itself will adopt new technology to prevent such an existential crisis. My guess is that it will most possibly be the genesis one because it will have the larger size of adopters who are fully incentivized to protect the genesis gene.

End of the day, to estimate S, one has to fully read and understand Bitcoin’s 10K (which is its whitepaper and codes). I just think most of finance people, like me, are not able to comprehend it thoroughly, thus maybe the finance side of me deserve less of credits in estimate S. Lastly, as a Chinese old proverb says “to throw a brick to induce a gem” (meaning to contribute a worthless point of view to induce valuable views), I am fully aware of my thoughts are bricks and I would love to see they induce gems.

 

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