Bitcoin’s price is more than 50% higher than its fair value of about $ 12,000.
That is one of the implications I draw from a new analysis of the various pricing frameworks for determining the fair price of the cryptocurrency. Entitled “Bitcoin Is Just Like Gold Except When Not,” the analysis was conducted by Claude Erb, a former commodity portfolio manager at TCW Group.
I first wrote about Erb’s analysis of precious metals in a February 2013 column for Barron’s. His conclusion at the time, reached in conjunction with Campbell Harvey, a professor of finance at Duke University, was that the fair value of gold was less than half its current price.
Gold fell $ 600 per ounce over the following 2½ years. That alone tends to me paying close attention to what he is now saying about Bitcoin.
This cryptocurrency has been on a tear of late, with earnings to date of 170%. In recent days, in fact, Bitcoin has risen to new all-time highs, echoing its previous high set in late 2017.
The pricing framework that concludes that Bitcoin’s fair price is about $ 12,000 is based on the thesis that its value derives from what is known as the “network effect.” That is, network value is growing faster than the number of connected users. (This framework is linked to the so-called Metcalfe Law, which claims that network value is growing by the square of user numbers.)
To test the explanatory power of this network impact framework, Erb made the simplified assumption that each Bitcoin mined represents one user in a Bitcoin network. He then calculated the way in which the price of Bitcoin has traded relative to the number of Bitcoins mined up to that point. As you can see from the chart that accompanies it, its model does a good job of capturing Bitcoin’s price rise over the past decade.
According to this model, Erb said in an interview, the fair price of Bitcoin on December 14 is $ 12,315. Bitcoin’s actual price on December 14 of $ 19,201 is 56% higher.
Of course, a social network framework is not the only way analysts have offered to calculate Bitcoin’s fair price. Nevertheless, Erb suggests we give it serious consideration because no other comparable pricing method is more empirically credible – and the predictions of the social network framework are implicitly related to the trajectory of Bitcoin’s pricing history.
Using the social network framework to price Bitcoin also allows us to predict how much it will rise in the future. That’s because its basic code specifies the maximum number of Bitcoins that will ever exist (21 million) as well as how fast they can be mined (this limit is unlikely to be reached until 2140) . According to Erb’s econometric model, a network of 21 million users translates to a Bitcoin price of $ 74,000. Relative to its current price, this represents a 1.2% annual return over the next 120 years.
Some other methods of pricing Bitcoin argue that it is a good inflation hedge. But Erb says those approaches are less empirically credible than the network impact framework.
He points out that a key precondition for something to be a good inflation hedge is that its real, or inflation-adjusted, price is relatively stable. But Bitcoin does not meet this precondition, at least if we use the consumer price index as a proxy for inflation. Over the past decade, the Bitcoin to CPI ratio has ranged from a low of nearly zero to a high of over 73.
Bitcoin is even less of a good inflation hedge than gold. That’s relevant because many Bitcoin fans argue it’s “Gold 2.0.” The gold / CPI ratio over the last decade has fluctuated from a low of about 3 to a high of about 8, and while that is wider than it should be if gold were a good inflation hedge, it is much narrower than the comparable ratio for Bitcoin.
The bottom line? Erb’s analysis offers something useful for Bitcoin devotees: a pricing model that can be used to estimate the fair value of the cryptocurrency. It is entirely possible that there is another model that does an even better job than its one of explaining Bitcoin’s pricing history. Meanwhile, Erb’s social network framework introduces a quantitative discipline to an arena that has been characterized in the past by marketing slogans.
Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee for auditing. He can be reached at [email protected].
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