What happened
Shares of Canaan (CAN -5.83%) were trending higher on Monday, after the price of bitcoin surged over the weekend. The company manufactures bitcoin mining hardware, so it stands to benefit from the rising price. As of 2:45 p.m. EDT today, the stock was only up 3%, but it had been 14% higher earlier in the session.
So what
In simple terms, when a transaction is made on the bitcoin network, a computer must validate it. Upon successful validation, new bitcoin is created to reward the computer owner who did it first. This process is called mining, and it creates a constant new supply of bitcoin. Computers "compete" to receive this reward, resulting in the need for ever-more-powerful computing hardware -- the kind Canaan makes.
Image source: Getty Images.
There's a real cost to mining bitcoin. Besides the hardware, there's also the electricity, among other things. If the price of bitcoin falls, then miners are in a difficult position. The business becomes low margin and there's nothing they can do about it. The silver lining is that there's less competition as miners give up.
Here's what could push the need for bitcoin mining equipment in coming months. Consider that mining gets more complicated over time, so miners always need to upgrade equipment. That's expensive, but it's justified if the bitcoin reward offers a profit after accounting for these hardware upgrades.
The price of bitcoin is controlled by supply and demand. On May 12, bitcoin went through a halving event. The reward for miners is now 6.25 bitcoin; it was 12.5 before. This means there's now less new supply. However, this doesn't guarantee the price will go up, since it does nothing to affect the demand side of the equation.
Over the past year, the price of bitcoin has been below $10,000 most of the time, and it's actually underperformed the S&P 500 over that span.
Bitcoin Price data by YCharts.
If the cost to mine bitcoin goes up, but the value of the reward goes down, then a miner's incentive is gone. Hence, there would be no demand for Canaan's bitcoin mining equipment. Indeed, Canaan's revenue in 2019 fell 47% year over year.
But over the past 24 hours, the price of bitcoin has suddenly spiked almost 10%. If this continues, expect that to draw more interest to bitcoin mining once again. That would be very good for Canaan.
Now what
The bitcoin halving event could be a catalyst to send the price of the cryptocurrency higher in the coming months and years, which would be good for Canaan. But it's hardly a guarantee. Cryptocurrency is a tricky thing to predict. Furthermore, investors interested in this should remember Canaan wouldn't be the only beneficiary from a surge in the price of bitcoin. In fact, several semiconductor stocks benefited in 2017 when the price spiked, and it could happen again.
Since the future of bitcoin is hard to predict, I would recommend looking for a company with strong operations outside of the cryptocurrency. That way, investors could buy a stock with a non-bitcoin thesis, but have exposure to the bitcoin cherry on top if the surge in price continues. Canaan doesn't fit that description.
