The best minds of the financial world think about how to determine the real value of an asset every day.
On my YouTube channel, I constantly say that it is necessary to buy an asset only at the moment when its market price is lower or equal to its fundamental value. Let’s see what is the difference between these two concepts.
Imagine that we decided to grow and sell, for example, strawberries. To do this, we have purchased the necessary equipment, tools, fertilizers, seeds, and so on. Let’s say that we needed $3000 for this purpose.
To facilitate the task, in our calculation we will not take into account all types of possible costs (the cost of electricity, the wages of workers, the necessary tax deductions, etc.).
If we had to take a loan to provide for the initial needs, for example, at 10% per annum, then each $1000 taken in a year would cost us $1100. So $3000 would cost us $3300 for a year.
We will agree that our initial funds were completely sufficient to buy everything necessary, and we did not need to take a loan at a certain percentage. In this case, we exclude from the calculation the cost of the capital necessary to start our own business.
Let’s assume that we managed to harvest 100 kg of strawberries. So, the real cost (the fundamental value) of 1 kg of our strawberries is $30.
Everything is a little different with the market price. The market price is determined by the volume of demand and supply of a particular product or service at a particular time.
By demand, we mean the intention to purchase a product or service (secured by the ability to pay a set price for it). A need that exceeds solvency is not a demand.
By the offer, we mean the willingness to provide the property (use) of the object of demand for a certain fee.
To put it more simply, the market price is the price at which the buyer is ready to buy (and the seller is ready to sell) the volume of goods we need.
In our case, the price at which we sell 1 kg of our strawberries will depend on how much people need our strawberries in general.
If we are the only sellers of strawberries in a certain territory and, at the same time, buyers really want to taste fresh strawberries, its market price can be as high as the last buyer is solvent. If not, everything will depend on how high quality our product will be for its price. At the same time, the price constantly varies for a certain period of time (seasonality and other factors). For example, if in winter we could sell 1 kg of our strawberries for $90, then in summer it is already for $50. The price of strawberries varies from $50 to $90.
The magic formula
Now we understand the difference between the fundamental value and the market price. If the first one consists exclusively of a set of real metrics, the second one is a variable factor that depends primarily on ”human factors“ (what is the maximum price the buyer is willing to pay, what is the minimum price the seller is willing to set at a particular time).
It is necessary to try to buy an asset only at the moment when its market price is lower or equal to its fundamental value.
However, how can you independently determine the fundamental value of an asset?
Unfortunately, there is no universal answer to this question, just as there is no universal “magic formula” (my sincere respect, Joel Greenblatt) that could determine the fundamental value of any asset on the planet. The point is precisely in the criterion of universality. If we consider each asset (or at least the market) separately, we can quite determine its fundamental value.
Even those things that seem to us to be free in everyday life have a fundamental value (their cost is simply negligible).
Three factors for assessing the fundamental value of Bitcoin
Let’s try to take a separate asset, for example Bitcoin, and do with it all the things that we previously did with our “strawberry business”.
First of all, let’s look at what the “powerful of this world “ say about the valuation of Bitcoin. Let’s turn to the news headlines (Figures 1–2).
Apparently, our idea is doomed to failure in advance. Is it possible that the analysts of one of the largest US banks, Morgan Stanley, could not (or did not want to) correctly determine the real (fundamental) value of Bitcoin?
Oops… only 3 years and we get a diametrically opposite picture from the news headlines. So could the bank’s analysts determine the fundamental value of Bitcoin, or did they just not want to share it with us? Let this question remain unanswered for now, and after reading this article, you will be able to give it yourself.
So, let’s start.
When assessing the real (fundamental) value of Bitcoin, we will take into account 3 main factors.
1. The maximum possible and current offer on the Bitcoin market
The reward for mining a Bitcoin block is reduced by 2 times every 210000 blocks. This fact is called halving (halving, “halving”). When all the blocks are mined by miners, the total number of existing bitcoins will be 21 million coins. You can learn more about this pattern in Figure 3.
Accordingly, the maximum volume of supply in the Bitcoin network will not exceed 21 million coins.
In reality, things are even better, since this volume also includes a certain number of lost coins. By lost, we mean all those coins to which the” private keys “ of their last owner no longer have access. For example, at the time of the appearance of Bitcoin in 2009, its real value was doubtful and not obvious to most of its owners, many of whom did not pay due attention to the safe storage of the asset, periodically losing access to hundreds and thousands of coins.
As a result, we understand that the final volume of supply on the Bitcoin market will be significantly less than 21 million coins.
To evaluate the offer, it is not enough to understand how many assets there are in total, because some of them, as we have already understood, can either be lost or be blocked for a long time. It is also important to take into account the criterion of “offers in time”. That is, the current total “ liquidity” of the network.
2. Hashrate of the bitcoin network
The main indicator of the viability and stability of the Bitcoin network is the hashrate (computing power). The graph is shown in Figure 4. Stable hashrate = network security.
3. The real value of the US dollar
When analyzing the Bitcoin / Dollar pair, it is necessary, in addition to the real value of Bitcoin, to also take into account the real value of the US Dollar.
There is an opinion that assets such as stocks or cryptocurrencies are extremely volatile (the price can change in a wide range for a relatively short period of time). At the same time, to reduce volatility, experts advise using the so-called “currency baskets”.
A currency basket is a certain percentage of foreign currencies in which the investor’s capital can be distributed. The ratio of monetary units in the basket is used to reduce the potential risk of currency fluctuations.
The main problem is that, due to inflation, the purchasing power of the currencies themselves decreases significantly over time (Figure 5).
For the $100 that we earned in 1913, already in the 1920s we could have purchased 50% less goods and services than before. In the 1980s, it was 90% less, and in the 2010s it was 98% less.
This fact should also be taken into account when assessing the real value of Bitcoin, since everything is relative, and in the Bitcoin/Dollar pair we determine the value of Bitcoin, expressed in US dollars.
The real cost of Bitcoin
After evaluating the relationship of the factors described above and drawing up a mathematical formula, we can begin to analyze the results obtained. In order to cut off unnecessary noise when constructing the function, we will use the 1-month graph (Figure 6).
Analyzing the resulting graph, first of all, the following catches the eye: the fundamental value of Bitcoin is growing over time. This is due to the gradual expansion of the network’s” user base”, as well as the growth of its popularity among investors of completely different classes.
I suggest comparing the previously obtained graph with the graph of Internet users (in % of the number of adult US citizens) in Figure 7. Similar, isn’t it?
The larger the number of Internet users — the higher its influence and economic potential. The greater the number of users of the Bitcoin network — the higher its economic potential and fundamental value.
However, understanding the fundamental value alone is not enough. We, as investors, first of all, need to understand: when to buy any asset.
To do this, let’s compare the graph of the market price of Bitcoin with the previously obtained graph of its fundamental value (Figure 8).
Now that we have a complete picture of what is happening and understand both the fundamental value of the asset and its market price, the fact of the numerical predominance of the price over the fundamental value for 116 out of 133 months becomes quite obvious (Figure 9). Periods of finding Bitcoin below its fundamental value are extremely rare and take only ~13% of the trading time.
About 87% of the total trading time, the market price of Bitcoin is higher than its fundamental value. Those rare periods when traders are ready to sell bitcoin below its fundamental value are an incredible gift for a long-term investor.
Bull and Bear markets
If buying Bitcoin (like any other asset) below its fundamental value is an absolutely incredible idea from the point of view of potential profitability, who in their right mind would sell their assets below this mark?!
It’s all about the emotionality of people. Saying “I won’t do anything stupid when the time comes” is easier than actually keeping your composure. Especially when it comes to money. Their money. And sometimes even about dreams.
According to classical market theory, it is customary to divide the market into two main phases:
A bull market is a period of time during which the price steadily increases (accordingly, the requests and expectations of traders gradually increase).
A bear market is a period of time during which the price systematically falls (accordingly, the requests and expectations of traders gradually fall).
There is also the concept of “correction”:
A correction is a temporary change in the price of an asset contrary to the main trend.
To date, there is not a single clear criterion separating the concept of a bear / bull market from the concept of a correction. However, it is safe to say that the change of the market (from bullish to bearish or from bearish to bullish) is interconnected with the fundamental factors of the market. Corrections, on the other hand, have significantly less connection with fundamental indicators and are rather related to the “physiology of the market” (nothing can only grow in price every unit of time for a significantly long time, nothing can only fall in price every unit of time for a significantly long time).
In this case, the most rational would be to define a bear market as a delay in updating the absolute historical highs of the price with a preliminary touch of the fundamental value (Figure 10).
Buying below the fundamental value is always a more reasonable idea than buying above the fundamental value, since, in most cases, it is the touch of the fundamental value that globally separates the bear and bull markets. The moments of purchases at the fundamental value of Bitcoin determined by us earlier are presented in Table 1.
Interesting fact: if we bought Bitcoin every time it touched the fundamental value, the average purchase price as of July 2021 would be $ 1,506. 65, which is 87% less than the current fundamental value of Bitcoin.
You can use this fundamental value indicator “MacroCorrelation “ for free.free” on TradingView (click).
- The total number of Bitcoins, as well as the speed of their production (mining) over time, are programmatically limited, which limits the volume of the maximum possible supply
- We are transporting Bitcoin, which means that the volume of supply for the current minute will also depend on the actual volume of assets available for sale
- The viability of the network is based on the number of computer capacities supporting it (network hashrate)
- When analyzing the Bitcoin / Dollar pair, it is necessary, in addition to the real value of Bitcoin, to also take into account the real value of the US Dollar
- Price ≠ fundamental value
- Buying below the fundamental value is always a more reasonable idea than buying above the fundamental value
- Do not believe the headlines of financial news and the public words of financiers
- Strawberry trading can also bring a fortune