Sorting Bitcoin’s P/E Ratio
This week, Glenn Williams Jr. uses his stock research analyst background—the land of price-to-earnings ratios and other valuation techniques—to determine whether bitcoin is undervalued or overvalued.
Next, Jennifer Murphy, CEO of Runa Digital Assets, puts digital assets into a very broad historical context (the year 1771 is mentioned) and explains how only a few winners tend to drive markets over a long period of time.
One of the things I enjoy most about writing this column is the opportunity to engage with readers and join them on a journey to learn more about this emerging crypto asset class. Sure I know some things, but there is still a lot to explore. Of particular interest to me is linking crypto to my background in traditional finance (TradFi).
I used to be an equity research analyst. My focus was on valuation. I have always viewed getting valuation “right” as of utmost importance and tried to answer two related questions:
If a company was trading below estimated market value, I would rate it a “buy”. If it traded over – well, in all fairness, I’d usually find another company to cover, rather than rate it as a “sell”. There are a number of dynamics in sell-side equity research that lead to such decisions, and perhaps I’ll discuss them in a future column.
I used a combination of fundamental and technical analysis, exploring both absolute and relative valuation techniques. Absolute valuations were based on the level of cash flows that the company generated, and relative valuations were based on its value in relation to a similar entity, or itself at an earlier point in time.
Unlike companies, bitcoin (BTC) and many other crypto-assets do not generate cash flows that can be based on a fundamental analysis. But bitcoin is not a company. Bitcoin is a peer-to-peer cash system that allows the transfer of value from one entity to the next, without the need for third-party validation. People see value in it, so value judgments should be explored.
Given that it has a fixed supply, some also see bitcoin as a hedge against the devaluation of fiat currency or against the actions of inept central banks. I see it as both, as well as a viable asset class where I choose to store some capital.
Over in stocks, the price-to-earnings (P/E) ratio is a common relative valuation. There are better valuation techniques, but it provides a quick comparison that tells you how much a company is being paid versus how much it’s making. The crypto version of P/E is the Network Value to Transaction (NVT) ratio. The calculation, created by cryptocurrency analyst Willy Woo, measures the relationship between market capitalization and network transfer volume. Transfer volume is analogous to earnings, and is simply a count of how much bitcoin is moved from one address to another.
In my view, for P/E and NVT to be comparable, you have to decide that observers value something about both. For companies (and thus P/E), shareholders value earnings. For BTC (and therefore NVT) it is the ability to store value in a digital asset, which I see as space on the blockchain itself. And as demand for that space grows, so does the value of bitcoin. If you can get your arms around it, the NVT ratio is worth including in your analytical framework.
High NVT ratios indicate that investors value bitcoin at a premium. Low NVT ratios indicate the opposite, potentially making a crypto asset alluring to investors who like to buy things at discounted prices.
But which numbers mean high or low? And when did these measurements take place? Given the age of cryptocurrencies, it is quite possible that what was overvalued in one period may not be in another. It also makes sense to look at where they are in relation to past history. And once again, it also makes sense to condense it over certain periods of time. What is overvalued in one time period may not be in another.
The highest bitcoin NVT ratio that I found on record was 448.15 on August 29, 2010. Was it overvalued? Well, BTC was trading for about 6 cents at the time, and is around $22,000 now, so the relevance of this reading is a bit questionable in my opinion. What if we throw out all data before 2014? That gives a maximum NVT ratio of 98.52, which I think makes more sense. Bitcoin’s all-time low NVT was 0.22 on January 24, 2016, when BTC was trading at $403. The average NVT over the investigated time period was 24, which I also think is relevant.
BTC’s current NVT is 44.89, an 82% premium to its average since 2014. But it is at a 20% discount to its 30-, 60-, and 90-day moving averages. It makes sense to me that the average premium attributed to a newer technology like the Bitcoin blockchain, and newer assets like bitcoin itself, would increase over time. It also makes sense to me that the extremes on both the high and low end will get narrower, which is what we’ve seen with the data.
Ultimately, the position one takes on the current NVT level will depend on what one is appealing to. Those who look over BTC’s entire trading history can see it as overpriced. But a narrower look shows that BTC can actually trade at a compelling valuation.
Stock market returns are overwhelmingly driven by a small group of winners. We expect the same trend in digital assets.
Between 1926 and 2016, only five out of 25,300 publicly traded companies drove 10% of the entire US stock market’s total value creation of $35 trillion: Exxon Mobil ( XOM ), General Electric ( GE ), International Business Machines ( IBM ), Microsoft ( MSFT ) and Apple (AAPL). Ninety shares accounted for more than half. Just shy of 1,100 generated the entire win; the rest collectively returned less than US Treasury bills.
Share returns do not fall along a normal distribution. They are positively skewed, with a few notable ones creating a “fat” right tail. Long-term investors who did not own these stocks risked missing out on the market’s average return.
We expect a fat right tail in the return on digital assets as well. Bitcoin (BTC) is a good example of a wealth creator. We compared the returns to market cap-weighted portfolios of the top 10, 50 and 100 digital tokens (excluding stablecoins and wrapped tokens) rebalanced monthly over the last five years. None of the broader portfolios fared better than BTC. The 50 and 100 token portfolios lost money during the period.
But why? What causes biases in the first place?
We believe a fundamental driver is technological revolutions. In her book “Technological Revolutions and Financial Capital” Carlota Perez defines these as “a powerful and highly visible cluster of new and dynamic technologies, products and industries capable of upheaval in the entire economy.”
Perez identifies five technological revolutions since the late 18th century:
Each period begins with disruptive technological innovations that attract talent and venture capital, creating an explosion of startups. Financial bubbles, corruption and collapse usually follow, eventually bringing regulation, management disciplines and productivity – a golden period of growth and profits. Since the Iron Age, the golden periods have been dominated by large companies. The longer the golden period, the greater the opportunity for winners to compound wealth.
Each of the five firms that drove 10% of all value creation since 1926 were market leaders in a recent revolutionary age:
In particular, each was founded at the beginning of an age, maximizing the opportunity to combine returns over many years. But just being there wasn’t enough. These winners envisioned a future others could not.
We are about 50 years past the dawn of the information age. It is likely that a new age is forming. Will it be the Digital Assets Age? In our view, digital assets alone are not enough to initiate a revolution. However, they are a powerful innovation that, along with others such as artificial intelligence, robotics and genomics, has the potential to form a new age.
If we are right, the winners of this age may be among today’s newcomers. Long-term investors would do well to ensure that their portfolios include potential wealth creators that will disproportionately drive market returns for decades to come. We think digital assets are strong candidates.
From CoinDesk’s Nick Baker, here’s some recent news worth reading:
