A way to value crypto assets

I've seen a handful of posts over the last few weeks attempting to determine the value of crypto-assets like Bitcoin, Ethereum, etc.

I don’t think anyone has figured out a good valuation method yet and it’s probably unknowable.

But I’m still going to try so follow along.

My first issue with the way that people are approaching crypto valuations is that they are trying to tie the valuation directly to the US dollar. The problem with this is that currency is only valuable in certain context.

Let me explain through a story.

Last year I went to Barcelona for NIPS and one night I ran out of physical euro bills. This made it hard to buy things. I, however, did have a $100 USD and at one point was trying to convince a shopkeeper to take the USD in exchange for some Iberian ham but he wouldn’t accept it.

So in that context my $100 USD was worth nothing.

Similarly almost everywhere accepts credit cards, but I always try to use my American Express (gotta get those SPG points), but in Barcelona AMEX only accepted in about 1 out of every 10 restaurants/coffee shops/cabs that I visited.

So that night, banks closed, with no euros, I found myself “broke” 9 out of 10 restaurant's I tried to go to.

When I change my context, however, my money suddenly was worth something. I went to the bank the next morning and asked the teller to exchange the USD for euros, suddenly my $100 bill was worth around $100 Euros which I promptly used to buy a cup of coffee.

This is the flaw with trying to value currencies with other currencies. It’s value depends on the context. So unless you are in a context that uses the currency, any “value” you are storing in the currency you hold is non existent.

This is because currency in itself is not very useful. Meaning a dollar, euro, Bitcoin, etc is only worth what someone else will give you for it.

Not all assets are like this.

Discounted cash flow

With non currency assets one of the valuation methods you can use is looking at the amount of cash the asset generates over a timeframe. For example, I can generate $30,000 a year by buying and renting out a 2 bedroom condo on the west side of LA. People will pay me this much because the condo provides shelter in a geographic location that is safe and accessible to the rest of LA. The utility of this home has the value of $30,000/yr, and because shelter is a basic necessity, there will nearly always be some amount money that I would be able to get from people in exchange for using the condo.

Over a reasonable holding period, say 10 years, the total value would be $300k in value generated by the condo. Thus if I can find a condo for less than $300k + my interest payments it would be a good deal —good luck finding that in LA.

Wow this is easy. Now let's try it with a currency.

If you take $10,000 USD in cash and put it in the freezer, in a year it would be worth $9,700 of today’s value.

Yep you read that right. Holding USD means the cash will be "worth" less next year. This is because of a 3% inflation rate.

Inflation basically means that the money you make today will be able to buy less stuff tomorrow.

If you are confused that's completely OK. It took me years to understand inflation and I still have a lot to learn. To begin to grasp the concept you first need to separate the "value" of something from its dollar amount.

So let’s do that.

As I mentioned before, currency is only valuable so long as the context (market) you are in values it. A market, by the way, is just a fancy word for “people exchanging something”. Thus the value of a currency really represents the productivity the people in the market think they can purchase with it outside of the market.

Put in plain terms since minimum wage in the US labor market is $7.35, $1 USD is “worth” hiring a worker for about 1/7 of an hour. This means that for 1/7th of an hour you can get some "stuff" done. For instance you could hire someone for 1/7th of an hour to pick 2 apples from your Apple tree so you can have apples with dinner.

So really you could say that $1 USD is "worth" 2 apples. Everyone believes this, including the apple picker who may grow his own tree, pick 2,000 apples, sell them for $2,000 USD and hire a web designer to design a website for his Apple picking business. The designer would accept the USD because he knows that someone else will also accept the USD because they will want to buy a portion of the next batch of apples that comes out.

Inflation means that a year from now, you will only be able to buy 1/8 of an hour with the same dollar --thus meaning you get less apples.

Why this happens is really out of the scope of this blog post, but my point is that the value of something doesn’t necessarily mean it’s dollar value.

So how do you value crypto assets?

One way of valuing an asset like Bitcoin by looking a the amount of productivity you can purchase with it. This is exactly like my apple example above.

I must admit that when I first started writing this post, I thought I would be able to easily find people who: a) have their hourly rate listed in Bitcoin, b) are willing to be paid in Bitcoin. I looked for a bit and there are quite a few of places (like https://www.reddit.com/r/Jobs4Bitcoins/ or https://www.xbtfreelancer.com) where people are willing to be paid in Bitcoin, but the fees are listed in USD, which is very interesting. [This is likely due to crypto’s insane volatility which I’ve talked about before.]({% post_url 2017-05-03-arbitraging-usdt %})

So, for now, valuing based on productivity turns out to be a dead end.

Maybe instead of the amount of productivity that can be purchased, we look at what was required to produce it.

Another way to value the condo above is by adding up the cost of all of the wood, cement, etc that went into building it. Valuing this way would basically be saying "if you wanted to build this condo it would cost you x amount".

The big assumption is the value of the labor, natural resources, etc that went into producing the thing, must be transferred into the thing.

What goes into making a crypto asset?

All of the crypto assets have different methods for adding to the supply of tokens to their blockchain but let’s talk about the biggest one: Bitcoin.

Bitcoin’s “proof of work” algorithm requires that for each Bitcoin to be "created" there is some "work" that needs to be done by a computer. This "work" is basically a number that the computer attempts to guess correctly. This guessing happens millions of times a second and burns burns a lot of energy in the process.

Using the “what goes into it” valuing method, the value captured by each Bitcoin would be the cost of the mining hardware and the energy used before the number is guessed correctly.

And this is where it gets interesting because to produce and distribute energy you need power lines, power plants, schools to train engineers, etc. This all makes energy very expensive.

In fact, energy is so expensive that governments tend to directly and indirectly subsidize its cost to make it less expensive for the people who live and work in the country.

The detailed breakdown of subsidy numbers per country would be interesting but are not really required. All you need to know is that subsidies are big. Globally they represented 6.5% GDP in 2016 —around $5.3 Trillion USD

Bitcoin gets more profitable when a) it's USD exchange rate is high, and b) energy costs are low. So what ends up happening is miners scour the globe to get access to cheap energy which also end up being energy that is heavily subsidized.

For example, in 2013 China spent the most in the world on subsidies —just under 2 trillion.

Guess where the largest Bitcoin mining operations are?

China.

Just to wrap some numbers around this, energy at my house is $0.20/kwhr. Miners in China pay < $0.04 /kwh.

This means that if I buy Bitcoin from a Chinese miner, what the miner is really doing is wrapping up the difference between my energy cost and theirs ($0.16 /kWh) into a security and selling it to me.

Assuming that the large miners use something similar to the S9s in production, the difficulty, reward, and amount of energy required to mine is equal across all countries at any given time. The main variables driving mining profitability being the exchange rate and cost of energy.

Sometimes the Bitcoin price skyrockets which makes it more profitable for more miners to enter the space in regions with lower subsidies. The bitcoin algorithm responds by adjusting the difficulty thus making it harder to mine Bitcoin. You can see this dynamic play out by looking at a price / difficulty chart.

![Bitcoin price and difficulty]({{ "/assets/images/price-v-diff.png" }}){:.center}

This is starting to all look like an energy arbitrage.

When I buy Bitcoin, as long as the energy used to mine the token is cheaper then energy I have access to, I’m getting a good deal. Which is the case almost every time thanks to subsidies and difficulty adjustment.

What this all tells us is that we can watch the relationship between Bitcoin’s price and difficult to see situations where Bitcoin is overvalued. These situations would be times where the difficulty rate stayed the same while the price continued to go up. I’ll explore this thinking some more in another post.

Bottom line, the best way to think about what any crypto is worth is to look at what goes into it. This means when you buy a Bitcoin, you are buying a securitized energy subsidy.

The subsidy value can be thought of as the delta between your energy and the country with the highest subsidy any given time.

So unless you have access to cheap energy, it’s probably a better deal than you think.

Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

*EDIT: under subheading "Discounted cash flow" changed 1/6 to 1/8*