How to Value Cryptocurrencies in the Future

Warning: Math Heavy Post! We're going to run a thought experiment on how we might be able to value cryptocurrencies moving forward which is based on information by Ark Invest, a Public Fund Manager within the Crypto space, that was presented in May 2017 at the Token Summit.

Here I want to break down Ark's Blockchain Products Lead, Chris Burniske's suggested model, add some value to it, and explain how it can be used to formulate the future value of Cryptocurrencies specifically using Bitcoin as our example.

The purpose of the post is to translate a part of Chris's presentation in a digestible way, while fleshing out certain aspects for you and for me :)

Understanding Two Key Underlying Values for every Cryptcurrency

To begin with we assume that

Market Cap of Cryptocurrency
= Utility Value of Cryptocurrency + Speculative Value of Cryptocurrency

Below I'll go over these two aspects and how they fit into our model

1 - Utility Value: 2 Ways to Look at It

Utility Value Definition: Utility Value is the underlying value that the cryptocurrency has once all of the inflated hype is stripped away. Another way of thinking of Utility Value is to assume that if the coin crashed on the exchanges, this is the final value it would rest at.

How do we determine the Utility Value of Bitcoin?

It's a bit challenging since we have to know what it's basically worth today if we stripped away all speculation on the exchange markets. From my research I have identified 2 Different ways we could approach this

• Remittance Market: The Remittance Market's primary use is to allow an individual to send send money from one country to a person in another. It is often used by wage earners working outside of their native country and sending money back home. Since Bitcoin and other cryptos can likely disrupt this space we'll be using this sector to go through a series of exercises
• Mining Cost: The simplest and most utilitarian approach to value cryptocurrency's Utility Value is how much it costs to mine it. Simple. See, if the market value of the coin is less than the cost to mine it, no one would mine it after all. There are many cost factors to take into account when mining, from the cost of initial hardware, to electricity costs, to upkeep, to the increasing hash difficulty. As an example, the cost to mine 1 BTC can range in value from USD $500 to USD $1000 or more. And as the difficulty increases this cost will only increase itself. Of course, once the cost of mining reaches a threshold that makes it entire unprofitable we may have to revert to pure transaction fee model, which would flip this method on its head.

We may further examine the Utility Value based on Mining in a separate article, but today we'll be using the Remittance Market

2- Speculative Value

Speculative value is what we traders tack on typically above the utility value. This value is what investors believe the FUTURE Utility Value will be, essentially (not to be confused with Market Cap). Today the Speculative Value of Bitcoin is somewhere between $0 and $2400 USD (current USD exchange rate for Bitcoin).

Is Bitcoin providing $2400 of Utility Value today? No. But, that added speculative value could be justified due to the bullish sentiment which entire industries and government policies are being developed around, suggesting a bright future for mass adoption of Bitcoin.

Remittance Market Overview and Disruption Opportunities

We will be using the Remittance Market to figure out the Utility Value of cryptocurrencies in this model. Currently the space is around $500 Billion, which over 230M people use to send money to foreign countries.

Remittance services are low lying fruit when it comes to industries that can be disrupted by cryptocurrencies. We'll be using Western Union and transferring money to India specifically in this case to understand crypto's benefits while we get a better grasp of how Remittance works and why it is a great fit to represent the Utility Value for cryptocurrencies.

Cryptocurrency's Benefits Over Current Remittance Market

• Currency Exchange Rate and Transaction Fees Savings: Western Union charges a Transaction Fee & specified Exchange Rate which likely is in their favor. These are entirely avoided via crypto, with the exception of the mining fees we pay for moving crypto from one wallet to another
• No Receiver/Sender Restrictions: Western Union limits who can send and who can receive. For example, if I'm working in the U.S. I can send money to India, but an Indian cannot send money to the U.S. through this service.
• Major Time Savings: Aside from transfers via cryptocurrency being nearly instantaneous the sender does not need to go to a Remittance Office in order to initiate the transfer. Similarly, the receiver would not need to physically go to pick up the funds from their local office either.
• Paperwork Reduction and Decentralized Bookkeeping: Removing the middle man entirely means cutting down on unnecessary paperwork, while having records clear and transparent on the Blockchain that cannot be fudged or lost.
• No Cap or Complications: Western Union limits the amount of money that can be sent to many countries due to regulations. Within that limit there are cash limitations too. For example, a receiver in India can receive up to USD $2500, however only $800 of that can be given in cash. The rest has to go through a separate process and will need to be deposited into a bank account.

Developing the Valuation Formula Further

Again the Value of a Cryptocurrency is implied to be its Utility Value + Speculative Value. We will be using Bitcoin as our usecase here.

Bitcoin's Utility Value in 2025

The following example will assume we are projecting Bitcoin's Utility Value in 2025

To understand Bitcoin's Utility Value we need to first understand the following in how we're valuing it. Keep in mind this is a thought experiment and NOT my predictions for the value of Bitcoin in the future.

• Bitcoin's Value in the Remittance Market: Let's assume Bitcoin eventually takes 10% of the Remittance Space by 2025 and that the size of the Remittance market stays the same size at $500B. That means Bitcoin is taking $500B * 10% = $50B of the Remittance Market
• Velocity: $50B represents the total amount of Bitcoin being moved back and forth between Wallets. To understand its Utility Value we have to understand what its Velocity is, that is, how many times the same Bitcoin moves between different Wallets.

In this case we assume the average value for Velocity is 5 times

Here's the Final Formula for calculating the Utility Value of Bitcoin
Bitcoin's Utility Value by Market Cap
= Remittance Market Value * Bitcoin's Share of Remittance Market / Bitcoin Velocity in Remittance Market

So, $500B * 10% / 5
= $10B USD is the Total Utility Value Market Cap for Bitcoin in 2025

This may seem incredibly low, but it's intended to be just that since it only takes into account how the currency is being used.

Bitcoin's Speculative Value in 2025

To calculate the Speculative Value in 2025 for Bitcoin we need to first calculate a possible Market Cap in 2025 by looking at a few things:

• Bitcoin's Current Marketcap: Doing a quick look up on coinmarketcap.com we see Bitcoin is worth around $40B today overall
• Bitcoin's Inflation Rate: Bitcoin has a very very slow inflation rate compared to a number of other cryptos, at around 4% annually
• Bitcoin's Discount Rate for Risk: Determined based on how risky an asset is, the higher the rate of risk the greater the return we expect when investing in it. Since investing in Bitcoin is far riskier than even the high tech stock sector, we assume a discount rate of 50% which is the yearly rate of return we'd expect to receive based on the likelihood it may fail

Putting the above together let's try to understand what the Market Cap for Bitcoin might be in 2025.

Bitcoin's Total Market Cap in Year X
= Bitcoin's Current Market Cap * (1 + Bitcoin's Inflationary Rate Per Year + Bitcoin's Discount Rate for Risk)^(Year X - Current Year)

Bitcoin's Total Market Cap in 2025 = $40B * 1.54^(2025 - 2017.5)
= $1.2 Trillion

Now that we have the Total Market Cap let's calculate the Speculative Value of that Market Cap

Total Market Cap of Bitcoin
= Bitcoin's Utility Value + Bitcoin's Speculative Value

So, $1.2 Trillion = $10B + Bitcoin's Speculative Value

--> Bitcoin's Speculative Value = $1.19 Trillion

Final Thoughts

Our thought experiment suggests that:

Bitcoin's Market Cap in 2025 = $1.2 Trillion
= $10B of Utility Value in 2025 + $1.19 Trillion of Speculative Value in 2025

Using the above you could model out alternative future values and use it as the base for other cryptos. Of course this is by NO means accurate or definitive. There are so many variables at play and many assumptions made that it really could amount to nothing. With that said, this is partly why I'm so interested in trying to find a metric that works in this nascent space.

Can there be such a difference between Speculative Value and Utility Value?

YES. Utility value can range typically from near 0% to 5% depending on the space. What this shows us is that Speculative Value can take up a considerable amount within the valuation of a cryptocurrency.

Now, if we used Mining as our representation for Utility Value we might also see a stark difference since the cost of mining is far closer to the Speculative Value than in the Remittance Market example. This goes to show that no one model really works yet, but it gives us food for thought and discussion.

What do you think? Is there a flaw in the assumptions above? Is there another way to value crypto's future value?

Sources:

https://qz.com/775159/theres-a-500-billion-remittance-market-and-bitcoin-startups-want-in-on-it/
https://india.westernunion.com/
https://www.forbes.com/sites/jasonbloomberg/2017/06/26/what-is-bitcoins-elusive-intrinsic-value/#63c907877194
http://www.cnbc.com/2017/05/31/bitcoin-price-forecast-hit-100000-in-10-years.html
http://www.bitcoinx.com/profit/

Images:
slashgear.com
http://openmarkets.cmegroup.com