How to value bitcoin

During 2009 the original exchange rate of bitcoin was calculated by dividing $1.00 by the average amount of electricity required to run a computer with high CPU for a year, 1331.5 kWh, multiplied by the the average residential cost of electricity in the United States for the previous year, $0.1136, divided by 12 months divided by the number of bitcoins mined by a computer over the past 30 days. The original value was US$1 = 1,309.03 BTC (http://historyofbitcoin.org/)

The question is how should we be valuing bitcoin now. Is it in a bubble due to greed driven investors not wanting to miss out on the next best thing, or is there more to the recent price rise and is there more to come.

To answer this question, I propose another question which by the end of this article will hopefully give us a clue as to what bitcoin should be valued at.

What is the value of any other currency, e.g. the US Dollar?

Since the dropping of the gold standard, where a currency was backed by physical gold reserves, we have been in a world of the Fiat currency, where governments control the supply of money.

1. A currency is valued by supply and demand
From a pure economics stand point, the value of an asset is driven by a simple graph of supply vs. demand. People are willing to pay more for an item if the demand for it is higher than the supply.
Take a simple example of oil:

Supply side:

as OPEC (Organisation of Petroleum Exporting Countries) agree to cut production the oil price rises *
rumor of war in the middle east cause the oil price to rise as people forecast supply disruption *
as shale gas mining technology improves and the US increases it's production capacity oil prices drop *

Demand side:

as economic growth (e.g. China or the USA) increases the oil price rises *
if there is a banking crisis, the oil price drops, as people forecast a disruption in the spending capacity of citizens *

In summary, the more demand there is for a currency the more that currency will be worth.

2. A currency gains in value as it becomes a key medium of exchange
The classic example of this is the US Dollar whose strength lies in the fact that

All currencies are quoted vs. the USD
Most commodities are quoted and traded in USD
The USD is the main currency used in international trade

3. A currency gains in value as people trust it as a store of value
An example of this is gold. Although gold has little practical use, it is seen as a store of value and people believe that it can be used as a medium of exchange should a country default or it's currency become worthless.

What has this got to do with the value of Bitcoin?

1. Supply and Demand
The supply of Bitcoin is fixed at 21 million coins (approximate 17m of those are currently in circulation)
As more people understand the blockchain and the usefulness of bitcoin, the demand will increase. Currently it is estimated that between 6 and 11 million people own bitcoin. In context more than 167 million people own shares, bonds and real estate (Palmbeach letter)

2. Medium of exchange

On April 1, 2017, Japan started recognizing bitcoin as a method of payment, similar to prepaid cards and gift certificates. Since then, Bitcoin usage and awareness in Japan have been growing.
I'm sure you have noticed, but on most Bitcoin exchanges, other coin prices are quoted in number of Bitcoins, linking it directly to the success of all other cryptocurrencies

As Bitcoin gains in popularity and expect to see other countries adopting Bitcoin as an acceptable payment method

3. Trusted store of value
Because of the technology behind the blockchain, and it's use of a decentralised ledger, it is rapidly being accepted as a trusted store of value.
In addition, it can't be manipulated by governments or central banks. The rules that govern the coin have been set

So how does this help us come up with a value for Bitcoin?

1. Supply and Demand
We know the supply side of the equation, but to estimate demand, lets assume simplistically that the value of the USD is a function of its Gross Domestic Product (GDP is the monetary value of all the finished goods and services produced within a country's borders )

There is $1.54 trillion in circulation
The total GDP of the USA is approx $18 trillion per year
That means that each USD generates approximately $11.68 per annum
If bitcoin were to valued on the same basis, but assuming it only contributes to 1% of the GDP, it would be valued at $10,588 (180bn/17000)

2. Medium of exchange
The value from this is more difficult to estimate, however if we take the value of a company like or MasterCard which generates revenue through use of their card we can estimate the value of Bitcoin

70-80% of revenues are from transaction costs
32million transactions are processed a day
Assuming that this is for 365 days, this would be 11.7bn transactions a year
It has a price to revenue/sales ratio of 10.55
It's total revenue for 2016 of 10.78bn, assuming that 70% of this was from transaction fees, $7.5bn
This would give the company a value of $79.6bn (based on price/sales of 10.55)
And finally a price per transaction of $6.80

If we apply this to Bitcoin, assuming the same logic,

an average of 72m coins per month traded between 01/16-04/17. This would give us an annual amount of 864m per year
an average price of $700 per coin for the same period with 17m coins in issue, the value of bitcoin was $11.9bn
this gives an average price per transaction of $13.77
If we assume the number of transactions will go up to 11.7bn a year, it gives bitcoin a current market cap of $161bn or $9,480 per coin

3. A store of value
It is estimated that there is 165,000 tons of available gold in the world.
There is 29,666 troy ounces (quoted weight of gold) in a ton, making close to 5billion ounces of gold in the world or a total market value of USD6 trillion (using a price of $1,200 per ounce)

If we assume the demand side of the equation is the same for bitcoin and gold and we divide the total supply of bitcoin (21m) by USD6trillion, we get an average price per coin of $280,000

In Summary

Bitcoin could quite easily rally to $8,000-$10,000 in the short term as it becomes a key medium of exchange and as demand increases with an upside of $280,000 in the future as people start to see it as a store of value