Trying to make sense of Bitcoin’s valuation

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Bitcoin, a decentralized digital asset, reached astronomical levels in the latter part of the last decade. Bitcoin is built on the concept of blockchain and the advent of blockchain technology, a revolutionary phenomenon. Blockchain is a public ledger that records all transactions and is implemented as a chain of blocks, where each block contains a cryptographic hash of the previous block.

Blockchain applications in the financial field are truly innovative and have been widely used in cryptocurrency mining. There are thousands of cryptocurrencies, but Bitcoin is the best known. In 2011, the price of one Bitcoin was around $0.30, and it took several years to capture the attention of the investing fraternities. It was around $998 in 2017 and in December 2017 it peaked at $19,783. Bitcoin has continued to spin, and it’s interesting to note how volatile the crypto markets (including Bitcoin) have been lately.

In this article, we try to investigate if there is a method to madness. The idea is to explore if Bitcoin prices can be captured using one of the valuation approaches offered by industry players/academics. There are several evaluation approaches, but we stick to the one proposed by Adam Hayes.

The argument of this model is that although Bitcoin is an intangible asset, it has intrinsic value and has similar attributes to mining commodities. The model is based on the concept of marginal cost of production which implies that Bitcoin prices should not deviate from its marginal cost. In other words, Bitcoin production can be visualized as a competitive market and therefore miners are expected to mine to a point where marginal costs equal marginal price.

Essentially, the model holds that the price of Bitcoin is a function of the following: (a) hash power; (b) energy efficiency; (c) energy cost; (d) relative difficulty level (difficulty of the mining algorithm) and (e) overall reward

According to the work of Hayes (2019), the cost of energy in dollars is $0.135 per kWh. The estimated average energy efficiency over the period from 2014 to 2021 is 0.09 J/GH. When Bitcoin was first launched, each mined block had a reward of 50 Bitcoins. This reward has been halved every four years, and based on that, the current block reward is $6.25.

The difficulty level comes from www.blockchain.com/charts#mining. The difficulty level only changes every two weeks, so we only use data from those dates. Using the model above, we try to predict the value of Bitcoin and then compare it with the actual observed price. The period of this study is from January 1, 2021 to December 31, 2021.

The predicted price from the model was compared to the actual observed price. The results are plotted in the figure and it can be observed that the observed price does not deviate much from the predicted price.

Historically, it has been observed that it is extremely difficult to value any new financial asset. For example, the valuation of Internet companies in 2000 was quite difficult because the business model was completely new compared to the then existing business models. Likewise, cryptocurrencies, non-fungible tokens (NFTs), etc. caught the attention of investors and the financial market would take some time to value these new financial assets.

Azmi and Subramanian are on the faculty of the Thiagarajar School of Management. Opinions expressed are personal

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Posted on December 8, 2022

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