Today, the Bitcoin is priced at $650 and has been price as high as $1200 and as low as $13 at the beginning of 2013. Yet, the price of Bitcoins seems a bit nebulous. Bitcoins have no inherent value and nothing to back them up. Bitcoins merely represent units of accounting inside a peer-to-peer network backed by nothing more than software and a network of computers. Yet, the software behind the Bitcoin does present a value as does its perceived value as a means of trade.
Now, this article is not too concerned with what Bitcoins provide as a value to users as this is well-documented by other sources on the internet. Here are some of the keys points to illustrate what Bitcoins bring to the table:
- 21 million Bitcoins is the maximum number of Bitcoins that can exist according to Bitcoin policy. This satisfies the scarcity requirement that a good store of money should have.
- The transactions are secure and are irreversible. Good for the merchant and with escrow good for customers as well.
- The rules of the Bitcoins are transparent and cannot be manipulative by a third party like the Federal Reserve. Any new rules must adopted by the community within the Bitcoin network.
Yet, what does this mean for the price of the Bitcoin and why? There are two perspectives the present value and the value with future expectation. This article is concerned with the present value and the methodology to get to a present value. Understanding the present value is a bit simpler, since there is no need to account for the risk. The risk is that the future expectation does not get met or Bitcoins goes the way of "MySpace" (meaning that at some point no one will use Bitcoins)
The reader should keep in mind that future expectation is quite high and the current value of Bitcoin would be considerably higher than "present" value. The reason is that there are a lot of good things that can happen and there is a lot of groundwork being laid down now that can and likely will lead to much wider adoption of the Bitcoin in the future.
The present value of Bitcoin is a function of the total number of users of the Bitcoins, the number of merchants that currently accept Bitcoins, and the number of transactions that occur on the network. Also, governments’ acceptance of Bitcoins as a legitimate financial instrument is a factor, but this factor plays more into the risk factor for future expectation. It is likely that most governments will view Bitcoins as innovation that will lead to economic growth and better tax revenue in the future. The US has taken this position and China is bound to recognize this as well.
The problem with first two factors is that it is difficult to get hard numbers for users and merchants. The news has reported that more merchants are accepting Bitcoins and more are to come. The number of users is growing, but the big question about the new users is why are they buying Bitcoins? However, it is relatively easy to get the number of transactions from the Block Chain. Blockchain.info shows charts with daily transactions as well as the "cost" of a transaction.
The "Cost" of the transaction is largely based on the value gained by new Bitcoins added and on network rules. Other insignificant factors include transaction fees imposed by network rules and
voluntary fees. The "Cost" calculated in US dollars comes to about $45 a transaction. It has been as high as $80 per transactions.
Computing the Present Value of the Bitcoin
A simple method for determining what the present value of the Bitcoins is to determine what the cost of the transaction should be. To keep the math simple, let's choose the value of $1. Such a cost is reasonable given that most of that cost would come from new coins getting created. A higher cost of $2, or perhaps $5 may be tolerable given that costs will come down once the number of Bitcoins getting created cuts in half in about 3 years and again in about 4 years and so on.
At a $1 per transaction the present value of the Bitcoin would amount to about $14 per Bitcoin. If we choose $5, the present value would be about $70 per Bitcoin. The point of this exercise was to show that current price of the Bitcoin is not sustainable unless it makes good on its future expectations. Yesterday, the network had 65,000 or so transactions. If that number were to increase to 2,950,000 million tomorrow, its current price would be justified (assuming a $1 "cost" is the right number). If a year from now it increases to 6,000,000 million a day then its current price would be about right, because you would expect to double your money in a year.
In conclusion, growth in the number of users and merchants is a good sign, but I believe they play more into the future expectations. People need to use the Bitcoins to justify the Bitcoins earned by Bitminers. The reason is the "Cost", although not realized by each transaction, does get imposed all Bitcoin holders. It acts like a hidden tax. The "Cost" will come down over time, but it will take years for this to happen on its own. Unless there is further demand, the price of the Bitcoin will go down just based on its current transaction "Cost".
