Fundamental Analysis of BTC, is BTC overvalued?

[picollo7]

As a casual economics thinker, I thought, what is the BTC really worth?

Forget all the bubble crap, forget the deflationary stuff, and forget all the nonsense about governments and whatever.  Forget about what everybody says, and just look at the fundamentals.

I realize that many people have an opinion one way or the other, but I am trying to be as objective as possible.  Full disclosure, I own some BTC.

How is a BTC generated? Work, from electricity, nothing more fundamentally.  Sure, you can get into the whole crypto stuff, but at the end of the day, BTC represents electricity spent.  You can also consider the initial sunk cost of the equipment, but in the long run, that cost becomes irrelevant.
 
The only thing that matters in the long run is the marginal cost.  As long as the barriers to entry are low, which they are VERY low, many people can enter the market to compete the profits away.

BTC is in its infancy, has very little widespread acceptance, is somewhat price "sticky," has low volume and is moderately easy to convert to other currency.

What does this mean?  It is great for the early adopter.  Let's look at how much a BTC costs.

Some assumptions that make sense in the long term and short term, possibly not the midterm:

1.  The cost of electricity is the ONLY relevant cost.  Why?  In the short term, your equipment has a high resale value; the money lost is negligible, and can be summed up as simple transaction fees.  In the long term, the cost of the equipment is spread out over such a long period of time that it is also irrelevant.  Especially after you consider the price of electronics approximately halves every 18 months, it is not a significant factor in determining the cost of a BTC.  (Even still, I will add a 20 percent rate of return so that miners can recoup some of the costs for purposes of the calulation.)  Additionally, after mining become unprofitable for some, they still have a perfectly functional computer that still has utility.

2.  The average cost of electricity will be assumed to be $.1 per kwh.  Some places more, some less, but if you don't like this assumption, take your own number and replace it, just multiply my final result by whatever factor.

3.  Using the latest growth rate of 8 percent a day, I assume linear growth.  I do NOT believe this to be a legitimate assumption, but it works for purposes of this exercise.

4.  I assume the highest efficiency of 2.5 hashes per joule.  Not realistic, but it gives a conservative estimate.  Also, assuming that the majority of the computing power is done by the most efficient computers is pretty valid assumption, especially considering the recent surge of computing power is most likely due to new miners seeking to capitalize on the insane profits, so it’s probably up there.

So currently, at a difficulty of about 244000, the electricity cost per BTC is about $.28.

28 cents! Are you kidding me?  As of right now, the price is 8.77.  You input .28, and you get out 8.77, nearly 32 times your input!  That’s insanity.  But is it?

The wonderful thing about this is difficulty increases.  The next difficult increase will nearly be double, and will happen sometime tomorrow (16 hours or less by my calculations as I’m typing this).  At an 8 percent growth rate, that is also growing itself, the computational power will double every 9 days, and the difficulty will lag behind.  This means the difficulty will ALWAYS be less than it should be, until the price of the BTC sticks at a certain price.

SOOOOOOO. . .

If we extrapolate out 2 months, assuming linear growth (which is conservative, personally I think it will be more exponential), and a lag in difficulty, then difficulty will increase approximately 1.75 times every round. (Personally, I believe it to be more, but I’m being conservative here).

Therefore, in 64 days, instead of the 28 cents of electricity per BTC, the price will be $25 per BTC.  So, it is not unreasonable to pay 8.77 NOW for something you think will be worth at LEAST $20 in two months.  That’s a whopping 768% annual IRR!

Now, I believe all these assumptions to be reasonable, but I cannot tell the future.  Currently, speculation is driving the price.  Although, I have to admit, the speculation is not completely unreasonable.

Conversely, there is nothing supporting the BTC.  It is ALL speculation.  I very much doubt the majority of BTC are being spent toward any form of economy.  It would be foolish, given the insane recent price increases.

As for now, it is clear that price drives the difficulty.  The price spike attracts people who enter the market and compete away profits.  This will continue to happen as long as a BTC is worth more than the electricity it costs to make.  It also attracts speculators, which also drive up the price.  As long as people keep demanding, the price will keep rising, because supply can only decrease.

The thing we have to worry about however, is a panic.  There will be a price ceiling that people will not be able to resist selling at.  It’s mass psychology, and it happens in every (dare I say it?) bubble.  In order for BTC to survive, it needs to gain significant economic traction: people need to USE BTC, SPEND it on goods and services.  There needs to be a fundamental utility to the BTC outside of speculation.  And in order for that to happen, the price spikes need to stop, but if that stops the majority price driver for the BTC will stop, the BTC will plummet, people will lose faith and not accept the BTC, further driving down the price etc.

It’s a catch-22.  The only way out is moderation.  If we moderately control the price, we can reach equilibrium, and the BTC will have a steady price, thus allowing people to SPEND BTC and for BTC to gain economic traction.  Fortunately, we have difficulty increases!  It is a very robust and smart system.  However, I believe the difficulty changes should happen on a shorter period, but that will all take care of itself in the LONG run.

I do know this: there WILL be an end to the speculation, and ultimately the BTC will stabilize and be priced at the marginal electricity cost, in the LONG run.  As to when that will happen?  I don’t know.  But I do know that the valuing the BTC at 32 times its marginal cost is NOT sustainable, is driven by speculation, and if it continues will only lead to a crash, dooming the short-term market to a crisis of confidence and slow growth.  However, given the robust nature of the system, worldwide spread, and huge available market, I believe in the LONG term the BTC is a viable currency, at a price slightly above marginal electricity cost (a price that would allow a 10 - 20% annual IRR on equipment).

TL;DR

The marginal cost of a BTC is only $.28.  The current price is $8.77.  If growth trends continue, in 64 days the marginal cost of a BTC will be about $23.  Will the market continue to value the BTC at 32 times marginal cost?  Doubtful.

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[Sweft]

What is fiat worth?  What is fractional reserve money printing worth?

You can't have your cake and eat it too.  

By your definition the dollar is worth nothing.  Absolutely nothing.  Too bad it's not true.  

The argument is dubious.

[silversurfer]

Your economics professors must LOVE you. 

Sell your Bitcoins if you believe what you say.

[nosacky]

You are right. People will be reluctant to spend a bitcoin if tomorrow it will be worth more. Yet, this is how bitcoins ALWAYS will be. Their supply is limited at 21 million, so we are doing a test for that period in the future right now.

[kjj]

Thank you so much for this wonderful analysis.

I was just thinking that we really need someone that knows neither bitcoins nor economics to start yet another thread about how wrong we all are for letting them get started too late to get a bunch of free coins by mining.

[smooth]

People will be reluctant to spend a bitcoin if tomorrow it will be worth more. Yet, this is how bitcoins ALWAYS will be.

People claim this a lot, but it's dead wrong.

The only five reasons BTC goes up in value from a fundamental perspective are:

1. It becomes more useful
2. Expectation that it will become more useful
3. It gains some kind of non-utilitarian subjective value, such as being a prestigious collectable.
4. Fiat goes down in value so the exchange rate for BTC goes up (not really increasing in value but appears to be).
5. It becomes more expensive to replace (i.e. difficulty goes up, electricity goes up, etc.)  I don't really agree with the argument that difficulty doesn't influence price (only the reverse) and I believe I could show that formally, but I don't have time to write it down.

Just because there is a fixed or declining supply of something doesn't make it go up in value.  There is a fixed or declining supply of one year old dog shit, but no one is going to pay more for it, ever.

[smooth]

I guess I could add a #6, although it's somewhat included in #5.

6. Competing crypto-currencies are seen to fail.  If it turns out that Bitcoin has too great of a first mover advantage (or less likely that it is indeed the ideal design for a crypto-currency) and other crypto-currencies are unable to compete successfully against it, then the threat of something replacing Bitcoin and making BTC worthless or near-worthless is reduced.

[picollo7]

 

By your definition the dollar is worth nothing.  Absolutely nothing.  Too bad it's not true. 

The argument is dubious.

*sigh*

No, a dollar is worth exactly the amount of work you put in to earn it, it is also worth the amount of goods you can trade it for.  The underlying value of the dollar, and any currency, is the amount of work you will spend to earn it.  Currently, the work for a BTC is the electricity input.  You don't do anything to mine BTC, your GPU does.

You totally missed the point of the post.  I am trying to arrive at an objective fundamental value for a BTC.  Even Satoshi Nakamoto, the CREATOR of bitcoin says that ultimately the value to converge toward the marginal electricity cost.

A price at 32 times the cost is pure speculation pure and simple.  I'm not trying to argue any opinion here, I'm seeking truth.  Everyone has an agenda when it comes to BTC.  If you read carefully, you see I have no agenda, other than to arrive at a fundamental price for the BTC.  I own some BTC.  I believe the price will go up, but I do not think it is accurately priced right now.

I am not dooming BTC.  I want it to survive.  I am warning against rampant speculation, which brought down the financial market, the housing market and every other market that crashed.

Let's be objective please and analyze what is really going on, instead of getting defensive.

Your economics professors must LOVE you. 

Sell your Bitcoins if you believe what you say.

Obviously did not read or understand what I said.  I said I am looking at the long run.  The price of a BTC is worth the amount of input work, which is the electricity.  The creator of the system himself said that, I'm not making this up.  If you look at my projections, and what I say, I don't think the BTC is overvalued, esp given the IRR.  What I'm saying is that the current price to cost ratio is out of whack.  Of course this will all change in 2 months, and in the long term, the situation will correct itself because of competition.

I was just thinking that we really need someone that knows neither bitcoins nor economics to start yet another thread about how wrong we all are for letting them get started too late to get a bunch of free coins by mining.

Uh what? That’s not even relevant.

Anyway, thank you smooth, finally a relevant answer.  What I’m attempting to do is arrive at a mathematical formula for BTC pricing.

[smooth]

A price at 32 times the cost is pure speculation pure and simple.

Well, sure.  The price of any liquid asset is based on a speculative assessment of its future value.  A less loaded word would be  "expectations." 

It's a bit like looking at a stock in terms of book value.  That's one measure of fundamental value.  But future earnings (or dividends) are another measure, and the two often diverge. 

[picollo7]

Ok, so what is a legitimate expectation of future value?  I posited a reasonable expectation in 2 months to be about 25 bucks for cost.  If the multiplier of 32 remains the same, this means in 2 months BTC will be 800 dollars? I don't think so.  I mean, I'd love it to be. I'm long on BTC, but I just don't see it happening.

[error]

Ok, so what is a legitimate expectation of future value?  I posited a reasonable expectation in 2 months to be about 25 bucks for cost.  If the multiplier of 32 remains the same, this means in 2 months BTC will be 800 dollars? I don't think so.  I mean, I'd love it to be. I'm long on BTC, but I just don't see it happening.

[kjj]

By your definition the dollar is worth nothing.  Absolutely nothing.  Too bad it's not true. 

The argument is dubious.

*sigh*

No, a dollar is worth exactly the amount of work you put in to earn it, it is also worth the amount of goods you can trade it for.  The underlying value of the dollar, and any currency, is the amount of work you will spend to earn it.  Currently, the work for a BTC is the electricity input.  You don't do anything to mine BTC, your GPU does.

So, a bitcoin that I mine is worth the cost of the electricity used to find it (production cost).  But, a dollar isn't worth the cost of the paper it is printed on (production cost), it is worth the amount of effort that I put into getting it from someone else (exchange cost).

Why is a bitcoin valued at the cost of production, while the dollar is valued at the exchange cost?

[smooth]

Ok, so what is a legitimate expectation of future value?  I posited a reasonable expectation in 2 months to be about 25 bucks for cost.  If the multiplier of 32 remains the same, this means in 2 months BTC will be 800 dollars? I don't think so.  I mean, I'd love it to be. I'm long on BTC, but I just don't see it happening.

It depends what expectations are going to be in two months.  I don't want to be too circular about it, but unless you base your analysis on value going all the way out, you can't really remove future expectations from the equation.

Some have made the argument that there is a potentially long growth curve ahead for Bitcoin in terms of usefulness.  If it captures even a small portion of funds transfers, or even just a good share of the underground economy that could be a lot of value compared to now when it's all pizzas and alpaca socks.

[picollo7]

By your definition the dollar is worth nothing.  Absolutely nothing.  Too bad it's not true. 

The argument is dubious.

*sigh*

No, a dollar is worth exactly the amount of work you put in to earn it, it is also worth the amount of goods you can trade it for.  The underlying value of the dollar, and any currency, is the amount of work you will spend to earn it.  Currently, the work for a BTC is the electricity input.  You don't do anything to mine BTC, your GPU does.

So, a bitcoin that I mine is worth the cost of the electricity used to find it (production cost).  But, a dollar isn't worth the cost of the paper it is printed on (production cost), it is worth the amount of effort that I put into getting it from someone else (exchange cost).

Why is a bitcoin valued at the cost of production, while the dollar is valued at the exchange cost?

A dollar IS valued at the cost of production.  How do you produce a dollar? You work for it.  How do you produce a BTC?  You work for it (mine it).  The difference is that with a dollar, you personally spend your time and effort, and with a BTC, you spend electricity.  They both SHOULD be valued on production, but BTC clearly is not.

[smooth]

Why is a bitcoin valued at the cost of production, while the dollar is valued at the exchange cost?

Production cost doesn't mean anything, but replacement cost does.

You can't take a piece of paper and turn it into a dollar, but you can take electricity (and computers) and turn it into BTC.  But even then, you can't do it right now (assuming you want BTC now) and you can't do it in unlimited quantity, so it's only an imperfect replacement.

[kjj]

By your definition the dollar is worth nothing.  Absolutely nothing.  Too bad it's not true. 

The argument is dubious.

*sigh*

No, a dollar is worth exactly the amount of work you put in to earn it, it is also worth the amount of goods you can trade it for.  The underlying value of the dollar, and any currency, is the amount of work you will spend to earn it.  Currently, the work for a BTC is the electricity input.  You don't do anything to mine BTC, your GPU does.

So, a bitcoin that I mine is worth the cost of the electricity used to find it (production cost).  But, a dollar isn't worth the cost of the paper it is printed on (production cost), it is worth the amount of effort that I put into getting it from someone else (exchange cost).

Why is a bitcoin valued at the cost of production, while the dollar is valued at the exchange cost?

A dollar IS valued at the cost of production.  How do you produce a dollar? You work for it.  How do you produce a BTC?  You work for it (mine it).  The difference is that with a dollar, you personally spend your time and effort, and with a BTC, you spend electricity.  They both SHOULD be valued on production, but BTC clearly is not.

My work creates dollars?  Well shit, does that mean the Secret Service is going to come after me?  Because I'm pretty sure they think that dollars are printed by the Bureau of Printing and Engraving.

Or, if you expand the notion of "dollar" to include checkbook money (accounts in a database) then a little research will easily demonstrate to you that electronic dollars are created out of thin air by bankers.

[MoonShadow]

Ok, so what is a legitimate expectation of future value?  I posited a reasonable expectation in 2 months to be about 25 bucks for cost.  If the multiplier of 32 remains the same, this means in 2 months BTC will be 800 dollars? I don't think so.  I mean, I'd love it to be. I'm long on BTC, but I just don't see it happening.

I don't either, but nor did I see a 100 fold increase in value in eight months when I bought in at 6.5 cents.

[picollo7]

Ok, so what is a legitimate expectation of future value?  I posited a reasonable expectation in 2 months to be about 25 bucks for cost.  If the multiplier of 32 remains the same, this means in 2 months BTC will be 800 dollars? I don't think so.  I mean, I'd love it to be. I'm long on BTC, but I just don't see it happening.

It depends what expectations are going to be in two months.  I don't want to be too circular about it, but unless you base your analysis on value going all the way out, you can't really remove future expectations from the equation.

Some have made the argument that there is a potentially long growth curve ahead for Bitcoin in terms of usefulness.  If it captures even a small portion of funds transfers, or even just a good share of the underground economy that could be a lot of value compared to now when it's all pizzas and alpaca socks.

We can all agree that it's based on expectations.  I think it's anybody's guess about the long term future.  The short term? I'm going to make a guess in two months: 50 USD.  I would not be surprised if it was 100, but conservatively, I say 50, based on an extrapolated growth rate, and a multiplier of cost to price ratio of 2.  Once the difficulty starts getting too crazy people will not mine as much, but it will still continue to grow, because difficulty increases lag behind growth rate.

Anyone else?

[smooth]

Once the difficulty starts getting too crazy people will not mine as much

People are going to continue to mine at much higher difficulty levels, even if that means botnets.

[abyssobenthonic]

Fundamental analysis of any monetized good will show that it is overvalued.

As a bubble in an asset of little-or-no elasticity of supply goes on without popping, that asset becomes the standard trade against which others are judged and thus becomes what is called money.

Bitcoin is a bubble.  By any analysis that doesn't, in effect, posit that there is a greater fool out there, the value of bitcoin is for all intents and purposes zero.

Gold is a bubble.  The demand level in the absence of greater fools is that of industrial demand.  The industrial price of gold is about an order of magnitude lower than the current gold price.  It's probably more overvalued, fundamentally, then most subprime mortgage securities were at the peak of that bubble (consider the returns earned by entities (mostly hedge funds) that backed up the truck to buy distressed subprime MBS...).

USD is a bubble.  The demand level in the absence of greater fools is taxation by the USG (thus zero if USG doesn't exist).  The value as a means of settling tax claims is well below the current market value of USD.