Rule Breaker's Guide to Cryptocurrencies, Part 2: What Is the Underlying Value of a Bitcoin?

The price of gold bears at least some relation to the work involved in mining it. Is there any equivalent for a cryptocurrency?

Motley Fool Staff
Motley Fool Staff
Dec 13, 2017 at 11:33AM
Financials

In this Rule Breakers podcast, Motley Fool co-founder David Gardner recruited Fool analyst Aaron Bush to help him with Cryptocurrencies 101. Turns out that a fair number of his listeners wanted more. So this week -- with bitcoin trading at more than twice the level it was for the previous episode -- he brought Aaron back for a more advanced encore.

In this segment, they try to unwrap what gives a bitcoin its value and explain why the market's opinion of that has been rising so sharply.

A full transcript follows the video.

This video was recorded on Dec. 6, 2017.

David Gardner: My friend, Evan DaSilva, a very thoughtful guy. I've mentioned him before on this podcast. He gives me good book recommendations and sometimes writes into the show. He wrote in about bitcoin. Aaron, you looked over that note, and I know we want to start there.

Aaron Bush: Evan had a few good questions and I can kick it off. He started with, "Hi, David. I just listened to your podcast on bitcoin -- twice, actually -- and it helped me a lot. I've been trying to understand it, and your podcast was especially helpful in explaining clearly how blockchain works. I had been having difficulty with that concept, and now my understanding is much clearer." I'm glad we could help you a little bit.

Gardner: Yes, and that's what we're going to keep trying to do this week, because it remains a dynamic, sometimes complicated world. We're going to keep trying to untangle things.

Skipping down a few paragraphs, Aaron, he went on to say, "Another question I have is how to determine whether bitcoin is overvalued or undervalued, considering it has no cash flow. When gold was money" -- and he's likening it as a store of value to precious metals -- "when gold was money, the amount of effort it took to produce the goods that an ounce of gold could buy equaled the amount of effort it took to mine the ounce of gold over the long run.

"Of course, if bitcoin truly becomes an alternative to cash, which is what it is at its core," Evan says, "then this same relationship should hold true. Could you figure out a way to estimate such a value based on that technique or any other technique you may think of?"


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Bush: That's a really good question, and we could have an entire podcast just about that. I'll answer that in two quick ways. First, I'll just say that the analogy that you gave with gold probably does fall apart at a point, because in the digital world, mining costs can change with simple code updates, and oftentimes there is no mining at all with many cryptocurrencies, so you can't really view that lens consistently.

So I guess, first of all, I'll just say one good or valid lens to think through crypto assets at large is this. Just like a business, you can take that underlying service or use case and extrapolate that out into the future. What do you think will happen? How big do you think this can be? How impactful can it be?

Then, once you have some guess or estimate about that, then you can try to understand its monetary policy. So this is things like what is its future dilution going to be? How much of the base is liquid? What are its transaction volumes like? And from there, taking both of that into account -- how big can the service be and what is its monetary policy building up to that scale -- you can get a rough estimate of what size of the monetary base is needed to support that level of activity. Discounted from the future back to the present, that is what we would consider its network value. In stocks it's often what we would call its market cap, so I think of those pretty synonymously.

And of course, precision is really hard, here. A lot of times you're trying to extrapolate from seed stage before anything has gone fully mainstream.

Gardner: Impossible.

Bush: Yeah, it's impossible, but that's probably the best attempt that you can get at something like valuation for crypto assets at large. Now with something like bitcoin specifically, and bitcoin is going to be an outlier here, compared to other cryptocurrencies, because people view it as a store of value. And over the past year we've seen bitcoin's price has risen far faster than its transaction volume. And to me that does make sense. Who sells things that go up? Who really wants to do that?

Gardner: Right. If I knew my $1 was going to be, in effect, worth $10 this time next year, why would I be spending my $1 right now?

Bush: Right. You wouldn't be using it as currency. You'd be using it more as a store of value. And in my opinion, there can only be one or maybe a couple of stores of value in the crypto world, and in that case the most important metric is the number of believers. So to the effect that any other news, any other metric affects the number of believers, and the number of believers then determines how much money is flowing throughout the bitcoin ecosystem, which then determines how much the network value of bitcoin is, I'd be thinking through it in that lens. A couple of different answers there.