December 2017 Update:
_{In a major update to the article below, I describe a different methodology for determining Bitcoin fair value. Since Bitcoin is gaining traction as a reserve currency rather than a daily payment instrument, it presents a more accurate method of predicting Bitcoin’s eventual fair market value. [Switch to updated article]}

Bitcoin is a popular investment at the moment with many people looking at this guide to buying Bitcoin with credit card in order to find out how they can profit off the buzz. An experienced investor recognizes a speculative instrument or commodity. Depending upon your frame of mind and your opinion about its future, Bitcoin is either a payment instrument or a commodity. But either way, its supply is capped (not by edict, but by an indisputable mathematical formula), and so its value is a product of simple supply and demand economics.

Value: What assumptions are reasonable?

I would never claim the foresight to predict the value of a bitcoin five minutes from now, let alone five years from now. Yet, I am baffled by its dollar exchange value today ($450 as I write this Wild Duck article). A reasonable and conservative calculation suggests that it should be-not $1200, as it was in late November 2013-but rather 100 times its current value.

Let’s consider one way to approach a calculation of the exchange rate necessary to support a low ball likelihood of its future utility…

Conservative Assumptions

• Let’s say that Bitcoin never achieves the status of a currency-and that eventually, the expectation of enthusiasts that it will become its own “value store” turns out to be wishful thinking. Let’s assume that exchange rate mania was no more than the Dutch tulip-mania.

• As a result, let us further assume that all speculative “investment” ends. Let’s just say that in 5 years, no one is interested in holding on to a bitcoin based on the expectation that its value will rise.

But, clearly, Bitcoin is very cost-effective when used simply to transmit money for a purchase, loan, gift, or exchange. Even if both parties expect to convert back to regional currency after a short time, it reduces cost and leads to increased retained revenue.

Furthermore, it’s cost effectiveness is maximized as users retain their receipts in Bitcoin pending their own purchase of goods and services. In this way, they avoid any cost associated with a round trip exchange.

• So let’s assume that consumers and businesses eventually hold 10% of their receipts in Bitcoin longer than a day. In this way, a certain amount of “coins” are required just to cover circulation.

Now, for more of our facts & assumptions…

• Today, 85% of transactions are US dollar denominated.

• Each day, the world needs about $3 trillion dollars to float current transactions. Additionally, the currency markets require another 3.98 trillion dollars for banks, exchanges, escrows, reserves and other activities driven by currency “markets”.

• Let’s further assume that these 2010 figures never grow. Despite China’s massive growth and significant recover in the west after the 2010 recession, we will effectively freeze the world economy at 2010 levels.

There is no reliable data on the turnover rate of purchase and settlements, cash reserves-or how long a dollar typically stays in an individual’s pocket.

• But if we assume that each dollar is turned over twice each day, we still require more than $3 trillion to grease the world’s daily needs. And that’s just US dollars.

Now, let’s make some reasonably conservative assumptions.

• Let’s assume that in 5 years, the faction of global transactions conducted online amounts to about 5% by value. (I believe that it is already far past this, but I am striving to be very conservative). If you have a business that deals with global transactions, you may want to look at global payment processing software to help with this.

• Let’s further assume that 5% of these transactions use a new age cryptocurrency built on Satoshi’s model.

• My boldest assumption is that Bitcoin will be the market leader in virtual currencies. If any become viable, Bitcoin will be involved in 90% of digital currency transactions. That’s because it has already attained critical mass as evidenced by media frenzy, attempts at regulatory action, and the comparative market caps for various “coins”.

For these reasons-and the mechanisms of a two-sided market effect, it is unlikely that two parties will find it quick, simple and inexpensive to designate an alternate cryptocurrency for their transaction.

Finally, here is a fact rather than an assumption.

• There are currently 12.6 million BTC in circulation (the Bitcoins that have been mined to date, less a few that have been lost). But the total number of Bitcoins that can ever be available is 21 million. That’s it. There will never be inflation. No one can mint additional coins to cover national debts, public works bonds, or war reparations. It simply cannot be done. Bitcoin is product of math and not of monetary policy.

O.K. So, where does this leave us? It leaves us with a fairly straightforward calculation. Let me set up the calculation this way:

If there are eventually 21 million “units” divided amongst a daily liquidity requirement for $6 trillion dollars. And, if we divide the liquidity assumption by our very conservative assumptions, how thin must you slice the unit to buy a house or a hamburger? Or, more specifically, what fraction of a bitcoin will be equivalent to $1 of purchasing power?

If I were to complete the calculation, my Blog subscribers would think that I have lost my senses! The resulting value of Bitcoin dwarfs any speculative assessment that I have seen-even those that don’t restrict their analysis to conservative assumptions. But just because I am copping out of the final numbers crunch, don’t let it stop you! Play with the assumptions and the numbers…Just don’t play with the facts!

Now, it’s your turn to speak up. Where do you think that Bitcoin will be in 5 years?

– Worthless?
– Still around $450/BTC?
– Or very much different?

Others perspectives on the value of a bitcoin:

• Finding Equilibrium: Searching for the true value of a Bitcoin – Vinny Lingham
  
• The Value of Bitcoin – Claudio Migliore
• Cryptonomics: Can we value Bitcoin? – Robert Sands

^{Disclosure: AWildDuck and its editors are charter members of the Cryptocurrency Standards Association.}