Bitcoin’s fair value is $20,851, according to the only valuation model I’m aware of for this best-known cryptocurrency.
Your reaction to this depends in part on whether you see the glass as half-full or half-empty. On the one hand, this fair-value estimate is less than half Bitcoin’s actual price of around $42,000. On the other, the model ascribes far more value to Bitcoin than those skeptics who insist that the cryptocurrency is worthless.
The model in question bases Bitcoin’s fair value on what’s known as a “network effect,” according to which a network’s value grows faster than the number of connected users. A well-known articulation of a network effect is Metcalfe’s Law, which holds that a network’s value grows according to 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 commodities portfolio manager at TCW Group. On the assumption that each Bitcoin that has been mined represents one user in a Bitcoin network, Erb calculates Bitcoin’s current fair value to be nearly $21,000. This fair value will grow as more Bitcoins are mined. (Erb posted on the Social Science Research Network his exploration of Metcalfe’s Law as it might apply to Bitcoin.)
You might be inclined to dismiss this Metcalfe’s Law-based model given how off-base it was last year. In December 2020, when Barron’s first reported on it, the model calculated Bitcoin’s fair value to be around $12,000 per coin. Over the subsequent four months, Bitcoin soared to over $60,000, before settling back to its current price.
Yet 2021’s experience isn’t a definitive basis on which to dismiss the Metcalfe’s Law-based model. 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 currently trades at 2.2 times its fair value, for example, if we base it on the 140-year average of the cyclically adjusted price/earnings ratio, or CAPE ratio, made famous by Yale University finance professor (and Nobel laureate) Robert Shiller.
In any case, Erb said in an interview, he isn’t proposing his Metcalfe’s Law-based model as the final word on Bitcoin valuation. Instead, he is offering 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 the cryptocurrency’s valuation that is sufficiently “intriguing” to warrant our serious consideration.
Is there any competing model that also merits serious consideration? It’s not clear there is. Perhaps the most widely repeated Bitcoin rationale is that it’s digital gold, which loosely means that Bitcoin’s market cap should be equal to gold’s. But this isn’t really a model in any meaningful way, since it’s “silent about when, and under what circumstances, there should be this convergence of market caps,” Erb argued.
Another Bitcoin rationale that has started to gain “currency,” so to speak, is that it’s a “Web 3.0 coin.” The underlying idea is that Bitcoin will take advantage of the third revolution the Internet is about to undergo: Web 1.0, the original internet, was what we might remember from the pioneering days in the 1990s in which 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, relying on decentralized blockchain technology.
Erb believes that no one actually knows what Web 3.0 really amounts to, and that its adoption by Bitcoin’s devotees represents little more than shrewd and clever marketing. After all, you might recall, Bitcoin was initially introduced as a global currency to be used in transactions. When that proved to be unworkable, the marketing message morphed into Bitcoin as digital gold. And now we have the added excitement of Bitcoin being a Web 3.0 coin, even if no one knows what that means.
Quoting the 17th century Jean François Paul de Gondi, the first archbishop of Paris, Erb said “Nothing sways the stupid more than arguments they can’t understand..”
With these strong words, Erb in effect is throwing down the gauntlet to those who believe Bitcoin is worth a whole lot more: Propose a different model that can be debated and analyzed. “If someone wants to come up with a better fair value estimate for Bitcoin than Metcalfe’s Law, fantastic.”
Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].
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