Is Bitcoin in a Bubble?

Is Bitcoin a bubble that’s about to burst?

Is Bitcoin in a bubble? Ah, the question du jour. More accurately, the question du every jour since about 2011. Don’t believe me? Just head on over to Bitcoin Obituaries and see the 169 times (and counting)  that Bitcoin has been declared dead/in a bubble!

What is a Bubble?

An economic or speculative bubble occurs when an asset trades at a price that is much higher than the asset’s intrinsic value. Sounds straightforward enough, but intrinsic value can be a difficult thing to define, so many bubbles are often only identified in retrospect. It’s possible to grasp the fundamentals of a bubble using some simple examples.

Bob’s Deli

Bob owns a neighborhood Deli in the town of Chester. The Deli has been in business for fifty years, and is a staple in town. In a single year, the Deli nets about $100K in profits after all expenses and taxes are paid. Bob has decided that he’s reached his sandwich constructing zenith and is looking to sell his business.

You’re a value investor, and you see an opportunity for steady cash flow in Bob’s Deli. It is unlikely that Bob’s Deli will increase its sales as the town allows no new construction and population is steady. You typically look for a 10% return on investment per year, so you decide to offer $1 million to buy Bob’s Deli.  Bob happily accepts the buyout, and you’re happy with your purchase.

This transaction has a foundation on sound economic principles, and a fair market value was paid for a business with steady cash flow, but this was a pretty straightforward scenario.

Sammy’s Super Duper Deli

Like Bob, Sammy owns a successful Deli. So successful in fact that He’s got 10 locations, each clearing $100K a year in profits. Sammy’s Super Duper Deli is creating quite the buzz, and it looks like he can add about 50% more locations per year without over-saturating the Deli market in his area.

In this scenario we have an additional characteristic to take into consideration: growth. Growth by nature is speculative, as there are many variables that can affect it. In this scenario, we’ll assume that the Deli can add about 50% more locations per year for the Next 5 years, which results in the following number of locations and net profits:

If Sammy’s Deli had no growth, we’d be tempted to offer $10 million to get a 10% return of investment in year 1. Sammy would reject this offer, because he believes that the company’s growth is sustainable, and will be pulling in $5 million in profits in year 5. Using something called discounted cash flow analysis, we take all of this information into consideration and offer a price of $70 Million, which Sammy accepts. We’re taking considerably more risk here, as year one net profits are only $1 million, but if this growth rate continues, we’ll be looking at about 380 locations in year 10 with a net profit of $38 Million, what a steal!

Carl’s Carb Free Deli

Carl’s got the hottest Deli in town. His single shop made a profit of $1 million last year and $2 million this year. What’s his secret? No bread! Going low carb is the new diet fad, and people are willing to pay a premium to keep that gluttonous gluten out of their diets.

Carl can raise his prices at will because he’s got the hottest product in town. The deli is grabbing so many headlines that a lot of investors are taking notice. Carl claims that the fad is only getting bigger, and projects profits of $6 million next year. He decides to solicit a buyout and visits a local investing group.

Carl is met by a dozen investors who are eager to catch the new hot fad. The stock market has been dragging lately, and Ed, a hedge fund investor, needs a hot new asset with a lot of growth potential. With all of the buzz about low-carb diets, Ed offers $40 million for Carl’s deli, assuming that Carl’s exponential growth calculations are accurate for next year.

Another investor, Luke, starts to panic. He wants a piece of this new hot asset class, the breadless deli. He’s going to roll the dice and assume that the exponential growth continues into year 3, and offers a whopping $80 million.

A third investor, Bernie, is really feeling the FOMO (Fear Of Missing Out). He’s willing to cast aside all basic economic principles and assume that Carl’s 100% growth per year is indefinitely sustainable. He takes the bidding war to the next level, offering $320 Million for Carl’s single deli. Carl quickly accepts this offer and signs the paperwork as quickly as possible!

The next week, Kim Kardashian posts a picture of her bubble-icious assets on Instagram, claiming that anyone can have a huge booty if they eat enough #bread. Suddenly, the low-carb fad is over, and the carb free deli can no longer make ends meet. Bernie’s left with a $320 Million pile of meat. In retrospect, this was clearly a bubble. Carl’s Carb Free Deli experienced 100% growth in the first year due to an incredible amount of short term buzz. Bernie was blinded by this growth, and incorrectly assumed that it was sustainable, ignoring the fact that this was a single deli with a realistic cap to how much money it can make.

Bubbles in the Stock Market

The Deli example may seem a bit far-fetched, but that’s because we’re looking at something that the average person has at least some familiarity with, a local deli. Although growth is hard to predict, it’s pretty obvious that a single deli cannot increase their revenues 32x in such a short period of time without major fundamental changes.

However, in the incredibly competitive world of small-cap technology stocks, this type of wild speculation is constantly occurring. Everyone’s looking for the next Apple, the world-dominating $800 Billion company that grew 1,000,000% since 1985. There’s perhaps no better case study than the dot-com bubble that occurred from 1997 to 2001.

The Dot-Com Bubble

In 1997, the internet was all the buzz. Any company with a .com at the end of its name was able to raise huge sums of money on the promise that their company, with the aid of the internet, would be the next big thing. This extended even beyond technology companies, with everyone’s favorite example being Pets.com. Pets.com ran a high-profile marketing campaign which helped make it a household name, but also destroyed its bottom line. In 1999, Pets.com spent $11.8 million on advertising, but earned revenues of only $619K!

Despite the weak fundamentals of Pets.com, the company was able to raise over $82 Million in their Initial Public Offering (IPO). Many investors saw this unbelievable valuation and instead of questioning it, they blindly jumped on board, pushing the company’s market cap to over $300 million! Cash flow fundamentals were cast aside, and the focus was put solely on the exponential growth that the internet promised. Within a year of the IPO, the company was no more, and a lot of investors lost a lot of money.

The potential of the internet led a lot of investors to cast aside fundamentals and make poor investments. Technology companies were aggressively priced, assuming massive growth an exponential profits, even though many companies had no profits and limited revenue. In retrospect this bubble can be easily identified. The chart below compares the NASDAQ, a technology stock index, to the S+P 500, an index that tracks the largest, most accurately priced companies in the world.

The exponential rise in the NASDAQ index price between 1999 and 2000 reflects the irrational exuberance for technology stocks during this time. The subsequent crash brought the index back to earth, as more rational metrics were used to analyze the value of the tech companies left standing.

The bubble was not without its winners, however. Smart investors were able to see through the irrational exuberance, and determine which companies actually had value and sustainable growth. Many companies died in the dot-com bubble, but future giants like Amazon and E-bay survived.

Bubbles and Bitcoin

Bitcoin is not a company like Bob’s Deli or Pets.com. For that reason, a cash flow analysis cannot be performed on Bitcoin. This would lead some people to say that Bitcoin is certainly a bubble, which I would say is an irrational and ill-applied analysis. Some would argue that the term bubble cannot be applied to Bitcoin, as a bubble implies a valuation that is a large multiple of some universally accepted idea of intrinsic value.

Bitcoin, like the internet, is a protocol. Bitcoin defines the rules for the transfer of value over the internet. In that sense, investing in Bitcoin is almost analogous to investing in the internet back in 1997. most people believed that the internet would be huge, but there was no way to invest in the idea of the internet. So, investors shoved an irrational amount of money into companies that used the internet in their business model. In the end, the internet succeeded and many internet companies failed.

The tech companies that survived the dot-com bubble were resounding successes. With today’s global economy and the proliferation of the internet, some companies have seen astounding growth. Amazon.com raised $54 Million in its 1997 IPO, and many considered the company to be in bubble territory with a total valuation of $438 Million. Today, Amazon has a market cap of $450 Billion, a growth of 102,000% since the IPO valuation.

The price of Bitcoin has risen from $22 in 2013 to $4,000 in September 2017. This is a rise of 18,000%. Many people look at this % rise and instantly declare Bitcoin a bubble, as it has grown almost 1/5 of the amount of the most successful company in the world in just 4 years! However, in 2013, almost no one had heard of Bitcoin. And although it had a market cap of around $200 million, much less money had actually been invested in Bitcoin. Many Bitcoins were mined, or given away to friends and colleagues to increase usage. Bitcoin was in its infancy.

In contrast, at the time of the IPO, Amazon was already a massive company with over $150 Million in revenue per year. Therefore, it is much more accurate to compare the amount of money invested in Amazon at the very early stages before the IPO to it’s current price. In Amazon’s infancy, it was a bookstore with a big vision. The company only had a handful of employees and a server in Jeff Bezos’ garage. It’d be generous to valuate Amazon at $1Million at this time, which, when compared to the current market price results in an astonishing growth of 45,000,000%.

I’m taking a little bit of liberty with valuations here, but the point is this: You can’t look at Bitcoin’s rise through the lens of the stock market. Bitcoin came into existence as a white paper in late 2008. It is perhaps more appropriate to look at 2009-2015 as the venture capital stages of bitcoin, with it gaining more of a mainstream exposure just recently.

The lack of underlying intrinsic value and the huge potential for growth make Bitcoin the most hotly contested investment of our time. It is clear that Bitcoin has all of the characteristics of traditional money, while bringing many new characteristics to the global digital economy. It is clear that the potential markets for Bitcoin are huge, and if Bitcoin captures even a small percentage of those markets, it’s current price of $4,000 a coin will be a steal.

Conclusion

Bubbles occur when an asset is valued at a huge multiple of its underlying intrinsic value. The dot-com crash and deli examples show how assets can be inaccurately priced due to irrational exuberance and unsustainable growth projections.

Bitcoin has seen a meteoric rise in the last few years, but is still dwarfed by the growth of the largest tech companies after their IPO’s. Bitcoin is incredibly hard to evaluate due to its massive potential and lack of classic intrinsic value. This makes Bitcoin a speculative investment with lots of volatility.

Despite Bitcoin’s recent price surge and increasing popularity, it is still in it’s infancy. Bitcoin is a world-changing technology, but will face many headwinds. Today’s valuation could be a steal if Bitcoin reaches its full potential.