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Why Bitcoin isn't overvalued (or undervalued)

I've written before that Bitcoin is powering an ICO bubble via mental accounting- but I was careful to ring-fence Bitcoin from the rest of the crypto-ecosystem. BTC has a plausible use-case as a store of value or as Silicon Valley's over-analogizers (including me) are wont to call it: "digital gold." Valuing it is completely different from valuing other assets- which is why I've to stayed on the sidelines, to my net worth's detriment.

To explain further, it is helpful to start with valuation first principles, and then show how they don't apply in this case.

First principles of valuation:

Investing is about getting a cash on cash return over time. For example, say I buy shares in a nail factory that generates a steady $3 per share of profit per year, with which the factory pays a $3 per share dividend. How much is each share worth to me? It depends on the return I require to keep my wealth tied up in the factory- if I want 10% per year, each share will be worth $30 (10x earnings). If I want 5%, each share will be worth $60 (20x earnings). This is the underlying dynamic behind most asset prices: stocks, bonds, real estate, you name it.

Of course, today many tech companies aren't valued this way, at least not explicitly. We use techniques like EV/Revenue or earnings multiples to estimate the cash generation potential of each share, without expecting the companies to pay dividends anytime soon. That said, the same math applies implicitly to them as well, and so changes in their valuations can be mapped to two sub-parts:

1) Changes in expectations about future cash generation

2) Changes in required rates of return

The lower the return investors require for holding a given asset, the "higher" the valuation is. Even if a company isn't paying dividends, it is priced such that it should (in expectations) provide a return to investors anyway through share price appreciation. The market is designed to go up in the long run, just as an investor holding a dividend paying stock would get more cash each year.

Once you think about it this way, it is inaccurate to claim that a given asset is "overvalued," and better to discuss its level in terms of expected future returns. For instance, one perspective on the stock market is that fundamentals have been strong and investors have been getting steadily less risk-averse, and that investors today are happy with a future return closer to 5-7% than the 8-12% that has been the long term average. There is no "right" required return, but as I covered in the mini-example above the difference between a 5% expected return and a 10% expected return is massive in terms of the price level assets trade at.

So when commentators say the market is "overvalued" they are really saying "investors are comfortable with lower returns than historical norms," and they are predicting mean reversion to those norms. It is true that, historically, the market has tended to mean-revert. It is also true that these mean reversions tend to be sudden and sharp. Neither of those need to hold though- time will tell.

One last point before I turn to BTC: as a true, super long term investor, you are not beholden to market psychology. Say the market hates nail factories and shortly after you buy the previously discussed shares for $30 they tank to $10/share. So long as the nail factory keeps paying a $3/share divided, the nail factory is still worth $30 to you and you're getting the return you wanted. You have less liquidity because no one is willing to buy the shares outright at what you think they're worth, but at the end of the day the original investment can still work out as long as the business fundamentals stay intact- all you need to do to get a 10% return is to hold on. When dealing with cash-generating assets, you can make investment decision without needing investor psychology to work in your favor, and you can pass on investments (either in individual stocks or the whole market) because you don't think they meet your required rate of return for the risk level.

This all seems useless, I grant, in a world where most investors are hoping to eventually sell to others down the road. But without a foundation of reality financial markets would act pretty differently, and we tend to get pulled back to this way of valuing companies in times of economic distress.

Valuing Bitcoin:

What makes Bitcoin different from other assets people invest in is that it is not designed to produce cash returns. It isn't equity, it is a commodity. This changes everything. A bet on Bitcoin is a bet that investor psychology will continue to change favorably.

The rules of economics don't apply here. Price is set by supply and demand as with anything, but there's no natural "demand curve" that lessens as the price rises, nor is there ever a great reason to sell based on price movements. For other assets, there is: at a certain point investors don't think the future returns are worth the risks and sell, and this process sets a price level. Of course, investors sometimes sit so many planes of abstraction above the real world that economic considerations are forgotten (see: The Dot-com bubble). Still, you could look at a dot-com and have an cogent argument about whether the valuation was justified based on claims about future cash flows and required returns. Those arguments just didn't happen too much until the crash.

Bitcoin is different. In Bitcoin's case it is impossible to argue it is overvalued or undervalued. Investing based on a price level is silly for a store of value- instead investors are generally making a valuation-blind asset allocation decision. Without an underlying cash flow stream to relate it to, we can't look to historical valuations and argue that it is "expensive". We also can't argue it is "cheap". You can argue that Bitcoin could eventually be "as big as gold" and use that to estimate how much each BTC would have to be worth for that to happen, but you'd be betting on the future demand for the asset. You're betting that HODLers keep the faith, that more will join them and that eventually many institutions see BTC as a genuine alternative to other stores of value like gold as the holder-base transitions into a more boring group looking for capital preservation rather than returns.

I know people way smarter than me who are making this bet. There's no intellectual hole in it, it is a valid bet. It isn't the sort of bet I generally like to make; and it is more akin to "educated speculation" than "investing" as most investors use the word, but it is a prediction about the future and you can make money if you're right which is pretty close to investing.

The caveat I humbly submit is that it seems to be the vast majority of Bitcoin holders are in it for appreciation, not value-storage, and that it is the appreciation that is attracting incremental investors, not a belief that Bitcoin is a stable store of value. Imagine if you polled BTC holders and asked them what they would do if they knew today that the price would be stable for the next five years- I bet most would sell. It may one day be a store of value, but today it is a means of speculative appreciation. Should the animal spirits abate and prices fall, it could do meaningful damage to the view that BTC is a safe store of value.

That is why there is some truth when people call BTC a bubble: it sure looks like one. Lots of people are buying an asset for appreciation that isn't constructed for appreciation, without any semblance of how to value it. All the classic bubble-hype elements are there: stories of an ocean of outside cash just waiting to get in (hedge funds, sovereign wealth funds, etc.), rapid appreciation without a fundamental catalyst, a fervent investor base with quasi-religious conviction, rampant greed and showy displays of wealth. Michael Lewis's retrospective will be a great read. As an investor, all of these things make me want to run from, or better yet, short BTC.

But I can't and won't, because it isn't overvalued. No one who is calling it a bubble confidently can claim it is overvalued either. It exists outside of their world, and they are mistaking that for weakness. There's a plausible world where BTC is a multi-trillion dollar asset, and it would be foolish to invest against that without a strong view as to why it won't occur.

All in, BTC is outside of the bounds of what I consider investing, so as an investor I'm sitting this one out. Which means I'm rooting for BTC to succeed. That way at least someone makes money on it. =)

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