Valuing Bitcoin and Eth

Summary

  1. A “market” allocation to crypto would be about 0.1% of net worth. Above that and you’re bullish on crypto.
  2. High Bitcoin holdings (e.g. 10–20%) imply even higher (e.g. 50%+) confidence in Bitcoin reaching the valuation of gold. [this is true even if you are valuing Bitcoin on some use case or basis other than gold]
  3. The value of things built on crypto is not the same thing as the value of Bitcoin (or Ether).
  4. Ethereum — by burning a portion of fees — has moved to monetise its network, making Eth more like an equity. Bitcoin has not done this, perhaps making it rely more on a store of value or means of exchange thesis.

1. Market Allocation

Consider an approximate market cap of $1 Trillion for Bitcoin and a market cap of $500 Trillion for all assets (real estate, stocks etc.).

Owning a market weighted portfolio of assets would thus result in an allocation of about 0.2% to Bitcoin.

Above this, and one is more bullish than the market. Below this, and one is more bearish.

Credit for this idea: https://twitter.com/punk6529 and likely people before him.

2. Bitcoin as a Reserve Currency

Consider a Bitcoin market cap of $1 Trillion, and a market cap for gold of about $10 Trillion.

A simple (and certainly non-unique) distribution that would fit this pattern is for bitcoin to have a 10% chance of being worth the same as gold, and a 90% chance of being worth zero.

Empirically, El Salvador appears to be the only country to hold some Bitcoin, while Tesla is an example of a company that has (or had) Bitcoin on its balance sheet.

Certainly, Bitcoin is a long way from adoption when measured by the number of countries adopting it in their reserve. Perhaps, framed this way, the market’s implied 10% chance of Bitcoin reaching the level of gold seems fair or even optimistic.

3. Kelly Criterion applied to Bitcoin as a Reserve Currency

To think this through further, consider taking the view (different to the market) that Bitcoin has a 20% chance of adoption to the level of gold, and an 80% chance of going to zero.

Interpreted this way, the Kelly bet, defined as follows:

would have p = 20%, b = 9, q = 80%, yielding the optimal Kelly bet of f* = 12% of one’s net worth.

In practise, one typically bets much lower than the Kelly bet. If betting 0.3 of the Kelly bet, that would lead to a bet of just under 4% of one’s net worth. The short reason for betting less than Kelly is that the payoff becomes flat at the optimal bet, and one loses less in return than one gains in reduced volatility by moving to a smaller bet size.

In short — at Bitcoin’s current price — if you are holding 10–15% of your net worth in Bitcoin, you are implying a very high (probably 50%+) level of confidence in Bitcoin reaching the levels of gold.

5. Bitcoin as a means of exchange

Were Bitcoin to be used as a means of exchange, perhaps its market cap would be similar to the M1 supply of the US dollar, which is about $20 Trillion (although was just $4 Trillion in early 2020).

To be used as a means of exchange, one would have to imagine a significant stabilising of Bitcoin price in terms of commodities and everyday expenses. With Bitcoin volatility what it is today, it doesn’t seem practical for merchants or consumers.

6. The Value of Bitcoin/Ether versus the value of what is built on crypto

There is confusion distinguishing between a) what value Bitcoin (or Ether) might reach, and b) what the value might be of what is built on or recorded on Bitcoin/Ether/crypto/blockchains.

Today, the value of all assets in the world is about $500 Trillion, most of which is real estate and equities. In theory, much or all of these assets could be recorded on blockchains. The “total value locked” on blockchains may reach a substantial portion of the world’s assets, but this is different than saying Bitcoin itself or Ether itself might become a substantial portion of the world’s assets.

7. Bitcoin/Ether as an equity selling decentralisation or trustlessness

One mental model is that, if you transact on the Bitcoin blockchain OR on the Ethereum network it’s because you value the decentralised records or trustlessness or convenience that it offers. To be specific, maybe you want the benefit of being able to transact in a country where you are blocked from transacting otherwise. Or, maybe you get a benefit from owning something digitally that can be verified in an open-source and trustless way by anyone with computer access. The closest analogy I can think of is the way in which people value the impartiality of courts (in certain countries for certain matters). One might think of Bitcoin or Ethereum as a court — greatly limited in what it can decide on, at least for now, versus courts — but not requiring trust in a single person or small court of people. When you transact on Bitcoin or Ethereum, you get to create your own record (often of ownership, either of Bitcoin/Ether itself or of some digital object) that is verifiable by anyone.

For some numbers to quantify this value:

  • Annualised transaction fees paid on Bitcoin are on the order of $150M as of early 2022.
  • Annualised transaction fees paid on Ethereum are on the order of $10B — higher than Bitcoin partly because of more transactions but largely because transaction fees have been 10X higher in late 2021.

With Ethereum Improvement Proposal 1559 that was recently passed, Ethereum has explicitly started to burn a portion of transaction fees, which is equivalent to doing a stock buyback.

Bitcoin currently does not have a mechanism to return value to Bitcoin owners (and many proponents might say never will).

Setting this aside, one can calculate a price (market cap) to earnings (annual transaction fees) ratio of about 30X for Ethereum and 5000X for Bitcoin. Certainly, Ethereum on this basis compares favourably with a high growth tech stock.

There is one major caveat to this analysis: I have neglected the cost to the Bitcoin and Ethereum network of block rewards, which currently outweigh Eth being burned (and massively outweigh Bitcoin fees). That said, it may well be the case that Ethereum becomes “cashflow positive” at some point as gas fees become larger than rewards.

Of course, users of crypto want transaction fees to be lower. They realise that, if fees are too high, users go elsewhere to Polygon or Solana or Celo. Further, the purpose of Ethereum 2.0 with sharding and support for rollups is to reduce transaction costs. So, if anything, these systems have natural forces pushing them towards greater efficiency to handle greater loads. Of course, with cheaper transaction fees there is more usage, so on net I still think that total transaction fees can rise over time but there is strong competition to keep down the cost of trustlessness. Generally though, it seems plausible to me that total Ethereum gas fees will continue to rise.

In contrast to Ethereum, Bitcoin has so far decided to limit the number of transactions per block. This might put more upward pressure on the price of Bitcoin block space (not necessarily the price of Bitcoin itself). Overall though, I think the price of space on the Bitcoin blockchain is subject to competition from chains that either currently exist or could exist.

Disclosures:

Don’t afford to bet what you can’t afford to lose.

I hold Bitcoin and Ether, as well as smaller positions in Ethereum and Celo blockchain tokens.

Further reading:

  1. Vitalik Buterin on medium of exchange token valuations: https://vitalik.ca/general/2017/10/17/moe.html
  2. Charts of crypto prices and volumes and fees. https://bitinfocharts.com/comparison/transactions-transactionfees-btc.html#log&alltime
  3. Ryan Allis’ spreadsheet DCF calc for Eth: https://docs.google.com/spreadsheets/d/1_IqNzqm-_Jlk-cK4twQ-bzhJKrsOhrckdQA2isTwKRA/edit#gid=0

Appendix: Forcing users to pay for transactions in Ether (or Bitcoin) doesn’t provide as much intrinsic value as one might think

It’s true that you need Eth in order to transaction on ethereum, and you need Bitcoin to transaction on Bitcoin.

However, if you can easily and cheaply convert between dollars and Ether, then you can just swap into Ether when you need some to buy blockspace. To the extent Ether can quickly be recycled to those who need it to buy block space, this keeps down the price of Ether according to the equation:

Number of Ether Outstanding x Price of Ether in USD = Daily volume of Ether transactions in USD x Average holding time of Ether.

Further, if you specifically want to record your ownership of Bitcoin (or Ether) on the blockchain, then it’s true you need to lock up your Bitcoin/Ether, which creates a net demand for the currency. However, this just brings one back to the argument of valuing Bitcoin (or Ether) as a reserve currency that can be transacted in a trustless manner.

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