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Why There's Confusion Over Valuing Bitcoin

Bitcoin presents a new type of nontraditional, highly technical, experimental, and global digital instrument to our already complex world. That fact should not conjure fear. It should engender excitement.

When I caught wind of Bitcoin as a newly minted MBA in the summer of 2012, I immediately scoffed. At the time, one bitcoin was trading at around $10, with a total market cap of about $50 million, which I thought was outrageous. It was a new, unregulated, "imaginary" Internet currency. Even though I initially rejected the idea as utopian, it stuck with me for some time thereafter.

Fast forward to early 2013, when the European banking crisis was reaching a fever pitch and Cyprus was on the verge of the first modern bank "bail-in." As the bitcoin price began to rise rapidly on a daily basis, and the situation in Europe continued to deteriorate, I decided to remove my "I know everything" MBA grad cap for an "I know nothing" crypto dunce cap. And, boy, am I glad I did.

The more I read, watched, and listened to bitcoin experts attempt to explain the most confusing and thought-provoking advancement since the Internet, the more fascinated I became, not only with the idea of frictionless transactions, but also by the idea of stateless currency.

Given the complexity of bitcoin (economic, financial, political, ideological), there are many topics of discussion that deserve specific attention in their own right. The Digital Currency Council does an excellent job of providing an overview of these issues in its free courses. In today's piece, we will focus on one of my favorite, and most misunderstood, topics: bitcoin valuation.

Valuing bitcoin: A traditional perspective
First, I think it is important to give readers an idea of just how difficult it is to categorize bitcoin for valuation purposes. Unlike equities, bonds, and real estate, bitcoins create no cashflow. Most traditional financial analysis is based on terminally valuing an asset's or entity's discounted cashflows in order to determine a fair present value price for those future cashflows. In the case of equities, the earnings of a particular company that are distributed as dividends can be theoretically extended in perpetuity and discounted at current "risk-free" interest rates, thus creating what is knows as a discounted cashflow (DCF) valuation. Since bitcoin has no cashflow, this method of valuation is not useful.

With regard to stocks, thousands of companies in hundreds of industries provide a pool of potential comparables to value companies from a comparative and/or historical perspective. Again, there is only one bitcoin (and it is the first of its kind), so there is no use for this methodology, either. There are "altcoins," but they are not proper comps for bitcoin. (That is a topic for another day).

Moving to bonds or other interest-bearing instruments, they too provide steady and somewhat predictable cashflows due to the interest coupons that holders of the securities collect at set periods of time. Once again, we run into a problem with bitcoin due to the lack of regular cash payments, though this can be programmed into the blockchain as an added protocol layer. (Again, that is for another time.)

Lastly, real estate projects -- at least those purposed for investor profit and not for proprietor dwelling -- also produce steady cash revenue in the form of rents and homeowners' fees that act just as dividends and interest payments. No surprise that bitcoin cannot fit into this category, either, given its currency/commodity-like properties.

So the obvious question is still "What is the value of a bitcoin, and how do we derive it?"

Valuing bitcoin: A commodity perspective
The Austrian economist's answer to this question is "It's worth what someone else is willing to pay for it, and that value is derived from the individual's economic utility at any given point in time," but this is a little too philosophical for our purposes. However, it does provide a nice segue from viewing bitcoin as a traditional cashflow-producing asset to viewing it as a hybrid virtual commodity/currency, similar to gold and silver but without the physicality.

This approach makes sense, given the scarcity element, which is inherent in both metals and bitcoin, as well as the lack of counterparty risk when holding the assets directly (i.e., not with a bank, custodian, or exchange). For these reasons, bitcoin and precious metals are sometimes viewed as relative stores of value.

Unfortunately, this is where the similarities end. Gold is corporeal, and bitcoin is virtual. Gold is difficult and costly to store and transport. Bitcoin is free to store and cheaper than a nickel to send. Gold has been used to store and transmit value for thousands of years. Bitcoin has had a monetary value for less than five years. Finally, gold is not beholden to electricity or connectivity, while bitcoin fails if either of those goes down.

It is obvious that both gold and bitcoin have unique advantages and disadvantages, and both have a place in a diversified portfolio. However, this insight still does not give us a decent basis for valuing a single bitcoin, especially since we can't even determine the fair price for troy ounce of gold.

Does bitcoin have a fair value?
So does bitcoin have a fair value at all at this point in its infancy? Is price influenced by geography, demography, or politics? Are high transaction volumes and merchant adoption more important to sustainable success than hoarding? This early in the game, these questions are yet to be answered. However, the circumstances leave us with a once-in-a-lifetime opportunity to develop new academic and operational models based on real-time information from the bitcoin blockchain and ecosystem.

The problem is that the blockchain technology is so new that the academic and intellectual underpinnings to develop such models are still evolving on a daily basis. This is yet another opportunity to do good and make money.

As far as the actual bitcoin price, at this point the most effective and widely used method of valuation by cryptocurrency professionals is pure technical analysis (historical price/time data analysis) and correlation analysis (correlations to stocks, gold, fiat currencies). Though they are suboptimal, these methods still work well in an inefficient and illiquid market such as bitcoin, but they too will soon need to evolve.

Though bitcoin presents a new type of nontraditional, highly technical, experimental, and global digital instrument to our already complex world, that fact should not conjure fear. It should engender excitement. Those willing to jump down the rabbit hole will be greatly rewarded financially, intellectually, and ideologically for taking the dive into Bitcoinland. They also just might be making the world a better place.

Adam K. Wyatt is Chief Analyst and Editor at BullBearAnalytics, a division of Digital Currency Research LLC, an informational financial publishing firm focusing on digital currency trading, investing, and education. Adam graduated with a BA in Economics and Political Science ... View Full Bio

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IvySchmerken
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IvySchmerken,
User Rank: Author
1/5/2015 | 5:09:18 PM
A Bitcoin Exchange Suspends Operations
Earlier today, Btstamp, the second largest bitcoin exchange, suspended operations, citing a security lapse, as reported by CNBC. These kinds of inciidents do not build confidence in the currency or the underlying tech platforms. In fact, one source in the artiicle suggests that a liquidity problem could be the reason and not a hacker.

The price of bitcoin has dropped to $250 from the mid-$300s, and was $ 269 today.

Venture capitailist Mark Andreeson went on a 26 tweet tirade defending the crypto currency. What do you think is causing the price volatiity if the mining and blockchain process is secure?

 
GlenLeeRoberts
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GlenLeeRoberts,
User Rank: Apprentice
12/31/2014 | 3:53:55 PM
Medium of Exchange
The real value, the real power of bitcoin is not as an investment for some wall street types, but rather as a medium of exchange that can serve as a stateless currency outside the grasping, maniuplating paws of politicians and bankers.

All it needs is to be used. There is really no excuse for any business not to be on board.
GatoMalo2
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GatoMalo2,
User Rank: Apprentice
12/31/2014 | 1:36:40 PM
Re: Suicide Cult
Bitcoin has gained value, were a year ago Bitcoin was this new weird thingy and today Microsoft, Dell and Overstock all take Bitcoins. It's all about the Public Ledger called the BlockChian that's were the real value is and as more JPMorgan and others start to play with Bitcoin the Value get's better and better. 

It's not your daddy's coin to investment, It's a new age and it a little different but the same. Bitcoin IMHO has gained more value this year then the last 5 years. Yes going 6 years old and the world is talking about Bitcoins = value...
GatoMalo2
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GatoMalo2,
User Rank: Apprentice
12/31/2014 | 1:29:06 PM
Bitcoin in the business world
Without the right tools business cannot function in Bitcoin today. I am building a HD-BIP32 Bitcoin business wallet. Adding Multi-sig wallets adds a 2 signature digital check- were it need 2 out of 3 authorization to send any coins. All in an easy to use application. You can create 100 to 1,000 of Bitcoin, Litecoin or Dogecoins sub-wallets and add multi-sig and then we add organization, mangement and accounting off all the sub-wallets and all the coins.

Without finding the right business people, developers like myself cannot do it alone, business needs the right financial tools and with Bitcoins it NOT about the value of the coins but the real value is the Public Ledger called the BlockChain. Financial data is everything and this is were all the magic - OK math and crypto but magic sounds better. 

You can NOT cheat math and crypto and the p2p network cannot be attacked the same ways so it safer and encrypted to boot. If you want to chat more my blog is uscyberlabs come on by and ask awya.

 
IvySchmerken
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IvySchmerken,
User Rank: Author
12/30/2014 | 12:05:41 PM
Re: Suicide Cult
As more regulations are applied to bitcoin, I would expect that bitcoins will eventually be held in ETFs or some type of funds. We are seeing an ecosystem develop with bitcoin exchanges and market makers. This is still evolving and in its nascent stages.  Private equity firms are backing many of the bitcoin business ventures. The IRS is applying long term and short term capital gains to bitcoin. [see a a bylined article by Kirk Phillips on our site, for more on this topic, soon to be posted]. We may be kidding around about bitcoins not being suitable for our 401ks. Yet we don't know what the future holds.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
12/27/2014 | 10:09:00 AM
Re: Suicide Cult
Very true. if my fund manager was investing in bitcoins in my moderate risk funds, i would move my $$ immediately.
IvySchmerken
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IvySchmerken,
User Rank: Author
12/23/2014 | 9:24:45 AM
Re: Suicide Cult
For the first nine months of the year, Bitcoin's price remained well above $400, but that's not counting a Bitcoin e-Flash Crash in August and a slump in July due to deposit freezes at Chinese exchanges, according to the site Coindesk.com

Bitcoin reached a low of $319 on Oct. 5 but began rebounding on Oct. 14, when the Coindesk BPI (Bitcoin Price Index) reached $398. But the recovery was rocky and short-lived.

In the past two days, bitcoin has been trading in a narrow range of $320 to $334. One site (Cryptocoinnews.com) is saying there will be little "overhead resistance" until $420. There are predictions that Bitcoin will double to $600 and based on Elliot Wave theory (technical analysis) could go to $1,200.

Clearly, bitcoin is volatile and is not an appropriate investment for one's 401k or 529 college savings plan.

 
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
12/18/2014 | 2:18:14 PM
Re: Suicide Cult
Hasn't it already lost value during the past 12 months?
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
12/18/2014 | 2:16:08 PM
Re: Suicide Cult
LeoTreasure,

For many investors, Bitcoins are a risky unknown with possible KYC problems.

How is Bitcoin addressing the KYC concerns that financial institutions currently face?
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
12/18/2014 | 2:12:39 PM
Re: Suicide Cult
Can you provide some additional information to help out our other readers? It will certainly help the discussion and it will educate the readers. Thanks!
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