Bitcoin investing: CIO breaks down how to value crypto, why to buy

  • Matt Hougan is the chief investment officer of San Francisco-based Bitwise Asset Management, whose $542 million Bitwise 10 Crypto Index Fund (BITW) has returned 242% since its launch.
  • Hougan and Bitwise researcher David Lawant break down five approaches to valuing bitcoin and cryptocurrencies in a new 64-page research brief published by the CFA Institute
  • Their research suggests that while there is no perfect way to value bitcoin, adding the digital asset to a traditional 60/40 portfolio has historically had a positive long-term impact on performance. 
  • Visit Business Insider’s homepage for more stories.

After a blockbuster year during which it gained over 300%, bitcoin appears to be headed towards an even better outcome in 2021.

The digital asset doubled in value in less than a month, jumping to over $40,000 per bitcoin as of Friday afternoon from $20,000 in mid-December. 

Even with the controversial and eye-popping rally thus far, many investors believe that the digital currency still has room to run. JPMorgan analysts said in a Monday note that bitcoin could reach $146,000 in the long-term as it competes with gold as a safe-haven asset. 

Guggenheim Investments’ global chief investment officer Scott Minerd suggested in December that bitcoin should be worth $400,000 based on its limited supply and store of value compared with gold.

ARK Invest’s founder and CEO Cathie Wood went even further and told Barron’s back in November that bitcoin could rally as high as $500,000 if institutions were to allocate 5% to bitcoin as they do to real estate or emerging markets. 

Aside from the few investors who dare to put a price target on bitcoin, predicting where the red-hot digital currency could go from here is a challenge. After all, bitcoin is notoriously volatile, as evidenced by its over 10% tumble to $37,000 after breaching $40,000.

Five ways to value bitcoin and other crypto assets

So how can investors value bitcoin and assess whether to buy, hold, or sell? Matt Hougan and David Lawant, the chief investment officer and a researcher at Bitwise Asset Management, break down the five approaches to valuing the digital asset in a new 64-page research brief published by the CFA Institute

The crypto asset manager’s $542 million Bitwise 10 Crypto Index Fund (BITW), which tracks an index of the 10 largest cryptocurrencies as weighted by market cap, has returned 242% since its launch in 2017.

(1) Total addressable market 

Hougan and Lawant pointed out that estimating the total addressable market of a cryptocurrency and comparing that with its current market cap is by far the most popular approach. 

In the case of bitcoin, most investors compare it to gold, which has a total market cap of about $13 trillion based on its current price of about $2,000 per ounce, according to their estimates.

“… the maximum number of bitcoin that will ever be available is 21 million. And so, the thinking goes that if bitcoin matches gold as a non-sovereign store of value, each bitcoin would be worth roughly $620,000 (on a fully diluted basis),” they said in the brief.  “If bitcoin captures 10% of the gold market, each bitcoin would be worth roughly $62,000; and so on.”

While easy to understand, the authors believe that this approach provides at best a rough estimate of the value that a crypto asset might attain.

(2) The equation of exchange 

The approach was introduced by venture capitalists Chris Burniske of Placeholder Ventures and Jack Tatar of Doyle Capital.

It is an adaption of the quantity of money theory, which states that the total amount of money that changes hands in the economy will always equal the total money value of the goods and services that change hands in the economy, according to Investopedia

In the context of cryptos, assuming bitcoin will process 100 billion $100 transactions per year, it will have done $10 trillion per year. Then assuming a bitcoin changes hands five times a year, its market cap should be $10 trillion per year/5 per year = $2 trillion.

Dividing $2 trillion by the fully diluted amount of bitcoin outstanding (21 million), it yields a price target of $95,238 per bitcoin, Hougan and Lawant explained.

However, they argue that the challenge in this approach lies in estimating the number of times a bitcoin changes hands per year.

(3) Valuing cryptoassets as a network 

This approach is derived from Metcalfe’s law, which theorizes that the value of a network is equivalent to the square of the number of participants. 

“If you consider a social network, such as Facebook, Instagram, or LinkedIn, for instance, its value when it has a single user is zero,” Hougan and Lawant explained. “If, however, a second user is added, the network becomes valuable. As more users are added, the network’s value grows.”

Ken Alabi, a Ph.D. in engineering from Stony Brook University, first proposed using the number of active daily users participating in different crypto networks to explain their valuation differences. 

While this approach makes intuitive sense, it is only suitable for comparing valuation differences among crypto assets. In addition, it gives equal weight to each participant, which makes more sense in ad-driven social networks than money networks. 

“For example, the decision by Paul Tudor Jones II in May 2020 to allocate 2% of his portfolio in bitcoin (and to promote that allocation heavily in his investor letter) is exponentially more important for valuation purposes than a new retail client at Coinbase buying her first $100 of bitcoin,” they said. 

(4) Cost of production valuation 

First proposed by Adam Hayes, this approach centers on viewing crypto through the lens of a commodity. Just like any commodity, the miners would not unearth it unless it is a profitable effort. 

“As a result, the value of each bitcoin can be estimated by examining the marginal cost of mining (specifically, the electricity burned in running the computations as part of mining) versus the expected yield of new bitcoin,” Hougan and Lawant said. 

Although there is a rough correlation between bitcoin’s price and the marginal cost of production, this approach’s “cause-and-effect relationship is not clear and its predictive value for the future is very much in question.”

(5) The stock-to-flow model 

First shared by an anonymous crypto quant researcher, this approach states that bitcoin’s price is a reflection of its scarcity, which can be measured by the stock-to-flow ratio.

The ratio examines the relationship between the existing value of bitcoin and the amount of new bitcoin being produced each year. 

However, Hougan and Lawant are skeptical of this approach.

“It is true that one of bitcoin’s strengths is its strictly limited supply, but assuming that this is the only factor driving its price is an overreach,” they said. “It is also overly convenient for crypto bulls because bitcoin’s stock-to-flow ratio is programmatically increasing over time and, therefore, “predicts” in this model a perpetually rising price for the asset.”

To own or not to own

Although there is no perfect approach to valuing bitcoin and cryptocurrencies, Hougan and Lawant found that most investors examine crypto assets through the lens of “some combination of commodity, currency, and early-stage venture capital investment.”

As for whether investors should add bitcoin to a diversified portfolio, Hougan and Lawant looked into how various allocations of bitcoin to a traditional 60/40 stocks-and-bonds portfolio might impact its performance.

They examined the period from January 1, 2014 to September 30, 2020 and considered rolling one-, two-, and three-year holding periods during the time period.

“Our analysis shows that adding bitcoin to a portfolio has historically had a significant positive impact on long-term portfolio returns on both an absolute and a risk-adjusted basis,” they said. 

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