Like other asset classes, there are models for measuring the value of Bitcoin and other cryptocurrencies. These models can be used to determine if Bitcoin is overvalued or undervalued.
I am going to be discussing three different models for valuing Bitcoin. There are:
- Purchasing Power Parity (PPP)
- Relative Value Vs Gold
- Supply/Demand
- Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is an economic term for quantifying prices in various locations. It assumes the law of one price; the law states that if there are zero transaction costs and trade barriers for a particular good, the price of that shouldn't differ in any location. In an ideal situation, the price of a PS5 in Nigeria and New York should be the same. If it costs $500 US dollars in New York and the same PS5 costs N570,000 in Nigeria, PPP says the exchange rate should be N1,140 for every 1 US dollar.
Based on that concept, The Economist created The Big Mac Index in 1986 to determine if currencies around the world are undervalued or overvalued. It does this by measuring each currency against a common product — the Big Mac hamburger sold by McDonald’s restaurants globally.
Bitcoin is not yet a local currency of any currency, its value would not be measurable by The Big Mac Index. The Big Sats Index was created to measure the value of Bitcoin against one Big Mac.
As of June 3, 2021, when Bitcoin was valued at around $39,000, 1 Bitcoin could acquire 6,639 Big Macs, while it costs 15,063 satoshis to acquire a Big Mac, according to Ecoinometrics.
However, this is not a proper model for valuing Bitcoin. As stated earlier, no country has Bitcoin as their native currency, so PPP cannot be applied to valuing Bitcoin. The Big Sats Index means the value of Bitcoin relative to US dollars to measure purchasing power, going this way would mean that the PPP for Bitcoin would differ based on the currency it is measured against.
Ultimately, until Bitcoin becomes mainstream and achieves global adoption and goods and services are priced natively in Bitcoin can we measure its value using the PPP theory.
2. Relative Value Vs Gold
The Purchasing Power Parity (PPP) model was applied to Bitcoin assuming Bitcoin should be treated as a currency. However, Bitcoin is considered more as a store of value rather than a medium of exchange. The concept “store of value” describes assets that can keep their value over time and not depreciate or be affected by inflation — an inflation hedge. These include precious metals such as gold and some currencies.
This means, to an extent, we can compare the price of Bitcoin to gold to determine if it is rightly valued or not.
The market capitalization of gold is $10 trillion while the market capitalization of Bitcoin is $738 billion. Ideally, since they are both functions as stores of value, they would be compared but this is almost impossible as there are different measurement metrics. Gold is measured in ounces while Bitcoin is measured in units, there is no midpoint or method of conversion for these metrics.
3. Supply/Demand
The value of every commodity traded in a free market is determined by the forces of demand and supply. For Bitcoin, supply is controlled by the code written in the creation of the Bitcoin network. The supply of Bitcoin is capped at 21 million units. In the network, miners create new coins by confirming transactions and adding them to the blockchain. The last Bitcoin is going to be mined in 2140.
On the demand side, it is tricky to determine what drives demand. People buy Bitcoin for various reasons such as speculative trading, inflation hedge, payments processing, and so on.
Final Thoughts:
All models are wrong, but some are useful — George E.P Box
This quote pretty much summarises my final thoughts. Scientific models — in all their glory — always fall short of the complexities that are present in reality, but, they are still useful. There are usually other factors that are missed or ignored in these models, some of these factors are not even quantifiable.
Sources:
