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Cryptocurrencies, Intrinsic Value and Greater Fools

Posted: November 1, 2017 | by: Thomas F. McKeon, CFA

Why is a Bitcoin worth more today than yesterday, last month or last year? An eager supply of Greater Fools will not last forever.

No doubt you have heard of Bitcoin by now. Bitcoin is merely the most visible “cryptocurrency” of the moment. Rarely have we witnessed such a frenzy around an “investment.” We use the word investment very loosely here because it is not at all clear to us that Bitcoin and their cryptocurrency brethren are legitimate investments. The frenzy is driven by the spectacular price action of recent months.


Bitcoin traded at $704.63 on November 1, 2016. Today, on October 31, 2017—exactly one year later—Bitcoin is trading at $6,312.94, an astonishing 795% gain. That compares to a 13.2% gain for the S&P 500 and a 25.1% for the MSCI Emerging Markets Index.


Of course, this kind of outsized gain attracts much attention and more than a little bit of promotion and prognostication.


I am an investment analyst by professional training. The goal of an analyst is to determine—as closely as possible—the intrinsic value of an asset. For a stock (equity in a company) intrinsic value derives from its asset base: tangible assets such as land, factories, equipment, cash, and intangible assets such as brand recognition, goodwill or patents. Assets less liabilities such as debt equals the company’s net worth or shareholder equity. Further informing the notion of intrinsic value of a stock is the company’s current and forecasted operating activities: revenues, expenses, investments, profits, dividends, etc. These cash flows can be discounted to derive a present value. From these assets and cash flows, analysts can estimate fairly well what a company’s intrinsic value is and whether the current market price presents a compelling entry point to invest (or not).


This estimation of intrinsic value works as well for bonds, real estate, preferred stocks, etc., where tangible assets, terminal values and cash flows support an intrinsic value and market price. Intrinsic value is central to the notion of prudent investing.


Why Is a Bitcoin Worth More Today Than Last Month or Last Year?

What is the intrinsic value of a cryptocurrency like Bitcoin? Why is a Bitcoin worth more today than yesterday, last month or one year ago?


Cryptocurrencies have no asset base—no land, property, equipment, cash, etc. They have no cash flows—no revenues, profits or dividend payments. They have no utility as do commodities like gold, platinum, soybeans or pork bellies. Unlike sovereign currencies such as the U.S. dollar, cryptocurrencies have no taxing authority nor are they backed by the full faith and credit of the government. As such, there is no way to estimate the intrinsic value of a cryptocurrency.


Moreover, cryptocurrencies don't solve a problem or address a need: the global banking and payments system moves billions and processes billions in merchant transactions electronically/digitally every day.  We suspect that the few merchants now accepting cryptocurrencies for payment only do so because they believe a cryptocurrency will be worth more tomorrow. Wonder how that will work out when cryptocurrency prices suffer a protracted downward spiral.


If cryptocurrencies are in fact currencies, why does their value change at all? Would you pay 7 dollars next year for one U.S. dollar today? Currency prices only move in relation to other currencies like the Euro or the Yen. True, the purchasing power of a dollar is constantly eroded by inflation. Yet a dollar is a dollar is a dollar.


In my estimation, cryptocurrencies have no intrinsic value. And without some reasonable estimation of intrinsic value, there is no way to determine an investment’s potential. Speculators in cryptocurrencies like Bitcoin are relying solely on the Greater Fool Theory—that some Fool (many Fools) will purchase more Bitcoin and drive the price higher. That very well may happen—until it stops. But that does not make it a legitimate investment.


The one year gain of 795% should be a red flag. Legitimate investments don’t have price gains like that, because intrinsic value does not change like that. Companies cannot spin intrinsic value out of thin air. Balance sheets and cash flows grow within the constraints of actual commerce: revenue growth, profit growth, and corporate reinvestment in plant, equipment, research and development, etc.


Market prices sometimes outpace intrinsic value, and then surely as night follows day, prices languish, correct back to—or even overshoot on the downside—intrinsic value. The market is after all the sum of all human behaviors about what investments are worth, so prices do fluctuate around somewhat intrinsic value.


Which brings me back to the core question: What is the intrinsic value of a Bitcoin or any other cryptocurrency? I don’t believe there is a good answer to that question. And as such, cryptocurrencies are not rightly considered investments. Rank speculation is more accurate. And as prudent, fiduciary investment advisors, rank speculations do not pass the sniff test and will never find a home in any Clothier Springs Capital Management client portfolio. 

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