A fundamental analysis of bitcoin

Originally published 6/20/21. Improvements made while turning this article into a video series in October 2022.

What is Money, Really?

T his is the question that anyone who seeks to understand bitcoin ought to begin with. Initially, such a question may feel like a mundane exercise, because we use money so often that surely we must already understand it, right? In reality, though, the question begins to get a bit philosophical, since money is actually a rather abstract concept. Most people haven't thought about it enough to provide a well-rounded definition. Someone might say "it's something that is valuable and can be exchanged for goods and services." But precisely what makes it valuable?

The most widely used form of money on Earth today is the U.S. dollar. So, let's take a closer look: what is a U.S. dollar? Well, if I were to hand you one, I would be handing you a piece of paper. There are laws surrounding that piece of paper, requiring it to be used in certain ways, but the physical entity itself is just paper. A $1 bill, $10 bill, and $100 bill are all the same size and same weight. If not in the mass or the volume, where exactly is the value stored?

Some might point to the dollar's history in response to this question. They might say that today's dollar is merely an imposter of its original self. The dollar was created with the Coinage Act of 1792, and was defined as essentially 21.4g of pure silver, or 1.6g of pure gold. This tied the dollar to mass; a $10 bill at this time did indeed directly reference a different weight than a $1 bill. Of course, this bond between precious metals and U.S. dollars has eroded over time, and in a seemingly sneaky fashion.

1928:

1934:

1963:

Source: @DocumentingBTC

So then, are precious metals the "real" money? Some might say yes; unlike a paper dollar, gold has intrinsic value. It has utilitarian uses. It is an important metal in certain industries and technologies, from dentistry to electronics. It is visually unique and attractive, making it a top choice for jewelry.

But here's where I must push back - I'd argue these statements miss the point. Gold is not valuable due to its utilities mentioned above. Not valuable to the tune of $1,800/oz anyway, if I am allowed to measure it in dollars here to convey my point. If you wanted to know how valuable gold is for these practical uses alone, you'd have to sell all of the existing gold bullion onto the open market, from the bars in central bank vaults around the world, to the coin collections of millions of individual investors. And once you did that, would gold jewelry still maintain its appeal as a demonstration of wealth? If not, you might have to sell a large portion of gold jewelry onto the open market as well, to paint an even more accurate picture. If you were able to perform this experiment, you would certainly see a massive increase to the supply of gold on the market, and minimized demand. The price of gold would be nowhere near as high as $1,800/oz in today's dollars. My rough estimate would place gold at closer to $300/oz (which could be fairly criticized, but the point is, the number is definitely much lower).

So why does it actually trade at around $1,800/oz? If we entertain my guess of a $300/oz "intrinsic value," why would gold on the market command a $1,500/oz premium? Why is so much of the gold supply allocated to sitting around collecting dust in bank vaults anyway? This concept is what I think a lot of folks end up missing. The truth is: being used as money is, itself, a practical use for something. If you take nothing else away from this article, please take away this. Gold was not chosen to act as money because it was valuable. Much of gold's value was derived from it being chosen to act as money. Similarly, U.S. dollars are not used as money because they are valuable. U.S. dollars are valuable because they are used as money. This is the key to understanding the value in bitcoin.

Those that claim gold has "intrinsic value" while the U.S. dollar does not, are misunderstanding what value even means. There is actually no such thing as "intrinsic value." Value is an entirely subjective term (it must be referenced to whom something is valuable), so how could value possibly exist intrinsically within anything? It can't. Things are simply valuable to people because those people view those things as appealing or useful. That's it.

It's true that a bitcoin, like a dollar, can't be used for much of anything... with one exception. It can, perhaps, be used as money. And that's all that matters. If it is used as money by people, then it is useful to people, and if it is useful to people, then it has value to them.

So why did people choose to use gold and U.S. dollars as money in the first place? Why would they consider starting to use bitcoin as money now? I ask once more: what even is money?

The Answer

The best definition I've seen for money is "a technology used to store and transport human energy across time and space."

A money succeeds in its task if you can perform work for someone right now to obtain it, and then you can send that money to someone across the globe 15 years from now and they will perform work for you in a similar capacity. Whether that work is to provide you with a service or a product, it doesn't matter. This is the utility of money. And in order for a money to do this job well, it needs to demonstrate certain properties. Understanding these properties will help us understand why gold and U.S. dollars have been chosen as money, and whether or not bitcoin can be a worthy alternative.

The properties can be categorized in a few different ways, but I will use a list of seven, in no particular order. I will describe each property in one paragraph, and then in each following paragraph I will discuss the property as it applies gold, dollars and bitcoin.

1) Fungible: A money should be fungible; in other words, each individual unit of the money must be interchangeable. I should be able to trade my 10 units of money for your 10 units money without any change to our wealth, because the units are indistinguishable from one another for practical purposes.

Both dollars and gold are good at being fungible; there can only be minor complaints about either. Bitcoin actually has the potential to become perfectly fungible, but first it must continue to resolve some technical privacy issues with UTXOs (the lightning network is helping here).

2) Transferable: It should be easy to change possession of the money from one person to another for a transaction (ignoring distance, which will be discussed in property #5). The transaction shouldn't take a long time to do. The money should be easily recognizable and easily verifiable in its authenticity.

Again, both dollars and gold are quite good at being transferable, because they can be handed to someone physically and immediately examined. Bitcoin currently has some issues with the speed of on-chain transactions (which is also being resolved with the implementation of the lightning network). Bitcoin also requires computers and the internet to facilitate a transfer, which is a downside. In the future this can potentially be offset by bitcoin-backed paper notes, bitcoin private keys loaded onto cheap hardware that can be physically traded, or something like this.

3) Durable: People shouldn't have to worry about their money being easily damaged while it is being stored or moved.

Durability has for a long time been a big feature of gold, which as an element is mostly inert / non-reactive, resistant to fire and water damage, and can be reshaped. Paper dollars are not very durable, but in digital form (debit cards, possible future CBDC), and with insurance from the U.S. government, their durability is also not much to worry about for the average user. Bitcoin's network has demonstrated high durability in its security, but it has had only a single decade to prove itself. Therefore it might be difficult to have confidence in its durability going forward, without delving into its technical mechanics or trusting someone else to do this for you. In its current state, many folks also consider bitcoin complicated to safely use, so there is a propensity for human error resulting in lost funds.

4) Stable Supply: The total supply of a money shouldn't fluctuate much, especially over short periods of time. Of particular concern is a money's resistance to its supply increasing, which would dilute savings and thus devalue human energy which had been expended in the past.

This property was a primary factor in people deciding to use gold as money over other metals, because gold is comparatively scarce and thus difficult to destabilize its existing supply. However, the current supply of gold on Earth is up for debate, and we know for certain that more gold can be found in outer space. Bitcoin on the other hand has a known supply cap that can never be exceeded, which is a pretty big deal and strictly superior to any other money humanity has ever had. At the other end of the spectrum, U.S. dollars are facing a lot of scrutiny these days since they are entirely at the mercy of the federal reserve, which claims to have "an infinite amount of cash." There has been a long and consistent downtrend in the purchasing power of a dollar, especially as it lost its original ties to precious metal.

5) Portable: Money ought to be easy to move across space; easy for someone to bring their money with them when they go somewhere, and easy to have it sent to someone far away.

This property is a primary reason for people moving away from gold and toward fiat currency like dollars. Gold's weight is debilitating for anyone wishing to move sizable quantities. Paper money is better, but sometimes struggles to effectively cross country borders. Bitcoin is ideal, since it has no weight or volume at all, and is moved by the internet.

6) Divisible: A money should be able to be efficiently divided into smaller amounts to allow for flexible purchase prices, and for change to be given when larger units of the money are used to buy something that costs less than the full unit amount.

This property is another reason why gold fell out of favor when compared to fiat currencies like dollars. It is much more convenient to use a system of dollars and cents than to try to divide up a piece of gold for a small purchase. But bitcoin is even better than dollars and cents, since its code allows for it to be easily divided into smaller and smaller pieces, essentially without any limit.

7) Acceptable: A money should be widely acknowledged as such among the population. This property could also be considered "stable in demand," because a money suffers if it has large fluctuations in its demand, or fear that it won't be accepted as payment.

Acceptability varies with time, and currently both U.S. dollars and gold are accepted in places worldwide. Dollars certainly aren't accepted for purchases everywhere, and I've never heard of a supermarket that will allow you to pay for your groceries in gold... but there is no doubt that bitcoin is currently the least accepted of these three competitors. While the supply of bitcoin is known, its demand has been fluctuating wildly, resulting in the volatility we've seen. Overall though, the adoption of bitcoin has been on a rapid ascent since its inception, and it is certainly reasonable to think this trend might continue.

Bitcoin as an Investment in Money Technology

Now that I have covered these seven principles, and used the principles to analyze the three money technologies covered in this article, I can assign approximate grades to them in a chart for visual learners. I've given my honest effort to approach these grades in an unbiased fashion but the bottom line is that these grades are my opinion based on the above logic. I don't expect everyone to agree on these ratings.

Source: Created by author in Apple spreadsheet

Where there are two grades shown and an arrow in between, I am trying to indicate that the first grade is what I would assign currently, and the second grade is how I see it potentially scoring in the future.

You may notice that in every single category, I've found that bitcoin has the potential to score either the same or higher than both gold and U.S. dollars. Let's break that down from a different angle.

I don't think anyone can reasonably argue against bitcoin being the most portable or the most divisible of the three competitors. I don't think people can reasonably complain about bitcoin's ability to be sufficiently fungible, either. When it comes to supply stability, I've seen some claims that bitcoin's supply cap is just an illusion, since there are infinite other cryptocurrencies out there that can do similar things. But this argument is flawed, since other cryptocurrencies are indeed entirely different entities. To illustrate, consider that bitcoin is specifically what is considered legal tender in El Salvador, not litecoin and not dogecoin. Saying that the supplies of each should be taken together as a whole is akin to saying that gold isn't scarce because the Earth contains so many other metals such as iron; it doesn't make logical sense. While some cryptocurrencies have similar code to bitcoin, they do not come close to replicating bitcoin's hashing power, the global network of people operating its nodes, and the combined dedication of its proponents.

So when looking at these four properties (being portable, divisible, fungible and stable in supply), I don't see any real contest to bitcoin's ability to serve as an effective money. The risks begin to show up with the other three properties (being transferable, durable and acceptable).

If you decide to invest in bitcoin you should be aware of these risks and you should conduct due diligence on whether it makes sense to believe bitcoin can overcome them. Remember that bitcoin's primary (if not only) use case is to perform as a new money technology, and if it fails this task, there is probably not much left to support its value.

In other words, if you bet on bitcoin, these are some of the concepts you are betting on:

1) bitcoin's ability to scale with second layer applications such as the lightning network, allowing it to be sufficiently transferable for quick transactions across a global population.

2) bitcoin's ability to remain secure, and remain adaptable to defend against new technologies, so that it is durable for decades to come.

3) humans acting rationally, so that if bitcoin continues to prove itself in all other categories, it will become more widely acceptable and people's demand for it will be less volatile.

Bitcoin Price Target: Approach One

If we are aware of the risks (and there are risks beyond what I directly mentioned above, such as political ones) and we believe that bitcoin has a chance of overcoming these challenges, then it makes sense to at least consider it as an investment and try to analyze the possible return.

If you have been following along until now, it shouldn't come as any surprise that the success of bitcoin would mean massive upside potential to its value. We are talking about it competing with and possibly winning against both gold and the U.S. dollar (and by extension all other metals and fiat currencies) to be the best money on Earth. In other words, using our earlier definition of money, the best technology on Earth to store and transport human energy across time and space. Of course, the implications of that would be quite large. It would mean that bitcoin is extremely useful, and therefore extremely valuable.

As I write this, bitcoin has a market cap of less than $1 trillion. How large is its competition? Using conservative estimates and slightly old numbers, the market cap of gold is approximately $10 trillion. The global narrow money supply (easily accessed fiat money such as coins, bank notes, and checking deposits) is around $35 trillion. The rest of the global broad money supply (savings deposits, time deposits, money market accounts) adds another $60 trillion. All put together, this is a space totaling at least $100 trillion.

If bitcoin were to move meaningfully deeper into this space, we are certainly looking at a multi-bagger return. If we believe bitcoin could attract even a small portion of wealth away from other assets as well, such as debt ($250 trillion), stocks ($90 trillion), derivatives ($10 trillion), and real estate ($280 trillion) then the upside could of course be even greater.

Click here for an interesting visual of the world's money & markets, used as a primary source for my numbers, complete with a list of its own sources used. The data was published in May 2020, so many of these numbers are extra conservative when used today.

If we think that bitcoin as a technology has enough potential to steal market share away from conventional money, it's not completely unreasonable to see bitcoin having a $10 trillion market cap, matching gold. Or, if you are a strong believer, perhaps a market cap much higher than that; but let's use $10 trillion for now. If that is our long term price target, it is 14x higher than bitcoin's current price (approx. $700 billion market cap). It would imply about $560,000 per whole bitcoin.

The risk/reward profile of bitcoin in this case would be rather interesting. Let's do a thought experiment involving EV (expected value). If we consider bitcoin to have just two possible outcomes: either it will be successful in achieving this $10 trillion market cap (let's say, 10 years in the future) or it will fail miserably and go to $0, then every $100 invested today would in 10 years result in either +$1300 or -$100. That would mean we would only need the likelihood of bitcoin succeeding to be 15% for this bet to have a positive EV. [Math: 1300p - 100(1-p) = 100; solve for p.] In other words, bitcoin could completely fail and become worthless up to 85% of the time, and if we simulated this situation again and again, our bet would still prove to be profitable in the long run.

Keep in mind, this is a calculation typically used by professional gamblers, not necessarily investors, because in real life we can't simulate situations like this over and over. This is simply a exercise to demonstrate the risk/reward profile of bitcoin in a hypothetical example. You could use this method to substitute your own price target and expected probabilities of bitcoin succeeding, to see if having an investment allocation to bitcoin makes sense for you.

Bitcoin Price Target: Approach Two

I'd like to turn your attention to one more very important thing that we have not yet considered in this investment return analysis. Up until now, I've been making price measurements in today's U.S. dollars, which can be helpful to imagine the possibilities of bitcoin's future purchasing power. However, given the special nature of this asset, and its direct competition with the U.S. dollar itself, measuring price in this way can be problematic in the longer term.

Firstly, we all know that new dollars are continually being added to the economy by the Federal Reserve, so dollars in the future are not expected to be worth as much as they are today. Beyond what we've already covered, this bodes well for the price of bitcoin, since its supply cannot inflate beyond a certain point. But secondly, if bitcoin actually starts to take significant market share away from the U.S. dollar as the most popular money, would that not further devalue the dollar? In other words, if people are placing more and more confidence in bitcoin, and using it as their preferred money, wouldn't that also mean that those people are considering dollars (and other monies) to be less desirable?

What exactly would this imply? The CEO of Microstrategy, Michael Saylor, recently famous for his large bitcoin purchases, explained his view on this concept in an interview earlier this year:

I think that bitcoin is sound money... it's the technically superior asset class compared to the dollar, the euro, the peso, the bolivar [and silver, gold, or anything else]... [When you ask me whether I will "take money off the table" by selling my bitcoin back for dollars, I just imagine we're in] Argentina and you're asking me if I'm going to sell my dollars and buy pesos back again as the peso slips from 20 to the dollar, to 40 to the dollar, to 80 to the dollar. Or if we're in, you know, Venezuela. I mean, you think a Venezuelan company is going to "take some money off the table" by selling their U.S. stocks and their U.S. dollars to buy back into the local currency? In Zimbabwe, you think they'd "take money off the table?" The point is, if you have the superior asset, it's going up forever, Laura. Forever.

Source: Michael Saylor, Video Clip

Something going up in price "forever" sounds a bit absurd at first. Forever is a long time. You wouldn't expect a stock to go up in price forever. If anyone told you that a stock is going to do this, you would probably be immediately suspicious of that person, and rightfully so. And if you are suspicious of Mr. Saylor, so be it, but it seems to me he has a point here. After all, measuring a stock price in the same currency that the underlying company uses to collect profits, is not at all the same thing as comparing one money to a completely different money.

There is a significant difference between a money's real purchasing power and the nominal price of a money, as measured by another. Saylor isn't claiming that the purchasing power of a superior money will go up forever, but that the price of a superior money will always go up relative to an inferior money. This makes a lot of sense: if we pick on Argentina for a moment, and agree that its pesos are technically a worse money than U.S. dollars (due to the peso's high levels of inflation and overall instability), it's no surprise that we see the peso's value measured in dollars decreasing over time.

Source: Xe.com

No one wants to be holding an inferior money, if they have a choice. If a money is inferior, that would mean it is a worse technology for storing their energy, and thus it is less useful to them and less desirable. And its price, measured in the superior money, will always trend downwards. If the Argentine peso ever stopped its gradual decent relative to U.S. dollars, and instead stabilized at a particular price, it would imply that people no longer feel it is inferior; rather that it is actually about equal in its desirability.

Really, the only things stopping an inferior money from falling to zero value immediately is the extent to which people realize it is inferior, and the extent to which they have the ability to trade it for something better. In Argentina, the government continues to enforce pesos as the currency of their national economy, and they've even imposed currency controls that restrict the ability of people to legally trade pesos for dollars.

If we return to bitcoin, and believe it has potential to be a superior money over U.S. dollars, we find ourselves in a very similar boat. If it is truly superior, and something doesn't cause this fact to change, bitcoin's price measured in dollars would indeed trend upwards forever. The price of one bitcoin couldn't simply stop at a number (let's say $560,000) and stabilize there, because that would imply that people consider $560,000 to be equal to a bitcoin in desirability, and therefore a bitcoin is not actually a superior technology for storing that amount of wealth.

Once the realization of a permanent upward trend sets in among enough people, bitcoin could potentially face a political risk of the U.S. government imposing currency controls of its own, restricting bitcoin's legal use. This could temporarily suppress the underlying truth surrounding its superiority; however ultimately the market forces of the world would be attempting to reflect that truth. It would become an epic power struggle between the laws of the U.S. government and laws of human nature itself.

Using this way of thinking to create a long term price target for bitcoin (in the event of its success) can only end with one answer. As dollars become less popular, and their use erodes over time, their value would shrink and begin to approach zero (and this could happen very fast, or very slowly over decades). Anything else that still maintains usefulness and value, when measured in dollars, would begin to approach a price of infinity. That would include bitcoin, of course. In such a scenario, it becomes rather silly to measure anything in dollars anymore, and to determine bitcoin's actual purchasing power we would have to refer to another method, such as the one I described in the previous section. To be clear, in this hypothetical scenario where bitcoin succeeds as the most popular money, bitcoin becomes the new unit of measurement for pricing things.

Infinity is a rather extreme conclusion, and so using this method to analyze bitcoin's price potential somewhat modifies the reason a person might want to own it in the first place. Buying bitcoin could be seen as less of an investment and more of an insurance, serving as protection for people holding other types of money that may end up becoming acknowledged as inferior. In other words, it could reasonably be perceived as a risk to store wealth purely in gold and fiat currency while a technology like bitcoin exists, and the most obvious way to mitigate that risk would be to start owning some bitcoin.

Conclusion

Bitcoin may not be physical or tangible, but it doesn't need to be in order to derive value. It just needs to be useful to people, and performing as money is indeed useful. Bitcoin is not a tulip, nor is it imaginary. It is a technology, and it exhibits properties that are comparable to the properties of other monies people have used in the past.

If you believe that bitcoin can overcome certain risks and challenges, and that it has the possibility of cementing itself as a superior money above what we currently use today, then bitcoin has potential as an investment option. It would be competing for a larger share of a $100+ trillion market (the market of money itself), offering plenty of upside potential. In theory, bitcoin measured in dollars could even approach infinity, which admittedly sounds suspicious, but only until the argument is understood.