What is the value of Bitcoin? Its fair value is much lower than the market thinks.

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The time of dreams

The fair value of Bitcoin is $20,851, according to the only valuation model I know of for this best-known cryptocurrency.

Your reaction to this partly depends on whether you see the glass as half full or half empty. For one thing, this fair value estimate is less than half of Bitcoin’s actual price of around $42,000. On the other hand, the model assigns much more value to Bitcoin than the skeptics who insist that the cryptocurrency is worthless.

The model in question bases Bitcoin’s fair value on what’s called a “network effect,” whereby the value of a network grows faster than the number of connected users. A well-known articulation of a network effect is Metcalfe’s law, according to which the value of a network increases with the square of the number of users.

One advisor who has explored the implication of Metcalfe’s Law for Bitcoin is Claude Erb, a former commodity portfolio manager at TCW Group. Assuming each bitcoin mined represents a user in a bitcoin network, Erb calculates the current fair value of bitcoin at nearly $21,000. This fair value will increase as more Bitcoins are mined. (Erb posted on the Social Science Research Network about his exploration of Metcalfe’s Law as it might apply to Bitcoin.)

You might be inclined to dismiss this model based on Metcalfe’s Law given how out of place it was last year. In December 2020, when Barron’s first reported, the model calculated Bitcoin’s fair value to be around $12,000 per coin. Over the next four months, Bitcoin soared to over $60,000, before returning to its current price.

Yet the 2021 experience is not a definitive basis on which to reject the Metcalfe’s Law model. The prices of all publicly traded assets are subject to wild swings above and below fair value; why should Bitcoin be any different? The S&P 500 is currently trading at 2.2 times its fair value, for example, if we base it on the 140-year average of the cyclically-adjusted price-to-earnings ratio, or CAPE ratio, made famous by the finance professor of Yale University (and Nobel Laureate) Robert Schiller.

In any case, Erb said in an interview that he does not offer his model based on Metcalfe’s Law as the final word on Bitcoin valuation. Instead, he offers it in the same spirit as those statisticians who like to say that “all models are wrong, but some are useful”. He suggests that his model is “a way to anchor a conversation” about cryptocurrency valuation that is “intriguing” enough to warrant our serious consideration.

Is there a competing model that also deserves serious consideration? It’s not clear. Perhaps the most widely repeated justification for Bitcoin is that it is digital gold, which loosely means that the market capitalization of Bitcoin should equal that of gold. But it’s not really a model in any meaningful way, because it’s “silent as to when and under what circumstances there should be this convergence of market caps,” Erb explained.

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Another rationale for bitcoin that has started gaining “currency”, so to speak, is that it is a “web 3.0 coin”. The idea behind it is that Bitcoin will profit from the third revolution the Internet is about to undergo: Web 1.0, the original Internet, was what we might remember from the pioneering days of the 1990s when AOL and Netscape were dominant. Web 2.0 is more or less the Internet we know today, dominated by social media companies. Web 3.0 will be the next generation of the World Wide Web, based on decentralized blockchain technology.

Erb believes that no one really knows what Web 3.0 really is, and that its adoption by Bitcoin enthusiasts amounts to little more than shrewd and clever marketing. After all, you may recall, Bitcoin was originally introduced as a global currency to be used in transactions. When that proved unachievable, the marketing message morphed into Bitcoin as digital gold. And now we have the added excitement that Bitcoin is a Web 3.0 coin, even though no one knows what that means.

Quoting 17th-century Jean François Paul de Gondi, the first archbishop of Paris, Erb said, “Nothing sway the stupid more than arguments they cannot understand.”

With these strong words, Erb is indeed throwing down the gauntlet to those who believe that Bitcoin is worth much more: Come up with a different model that can be debated and analyzed. “If anyone wants to come up with a better estimate of fair value for Bitcoin than Metcalfe’s Law, fantastic,” he said.

Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at [email protected].

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