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Valuing stocks versus valuing Bitcoin

Is it time to buy Bitcoin? Is there too much froth in the market so selling Bitcoin makes more sense? Or rather, should you wait for a massive correction to clear air pockets and then buy Bitcoin to ride the long term wave?

At any point, you can find arguments supporting these and many more takes on the Bitcoin market. The truth is, no one really knows the answers despite their level of confidence in being able to read the markets.

Perhaps a better approach is to determine for yourself if the current value of Bitcoin is above or below what it should be i.e. determining if BTC overvalued or undervalued.

There is no single best way to perform such an analysis. Taking a long-term broad perspective on wealth management, economics, and the way we value assets, BTC is still in its early days and as an entirely new asset class there is no real consensus yet as to how to determine the price of Bitcoin.

That said, perhaps we can apply some of the principles that inform stock valuations – a market that has evolved over the last 5 centuries starting with the first “stock” exchange in Antwerp in the 1500s.

How to value stocks

Probably the most important skill an investor needs to learn is how to value a stock. Without this, investors are at the mercy of noise in financial media, fomenting FOMO and emotionally driven trading. But if you know how to value stocks, you can determine if a company’s future growth projections are already baked into the stock price or if the shares are actually undervalued for example.

There are two main approaches to valuing stocks: quantitative and qualitative. The former involves a range of metrics and calculations to determine the intrinsic value of a stock, the latter looks at the context in which a business operates to assign relative meaning to the value of a stock. Combined, these two approaches help to value stocks.

Quantitative ways to value stocks

The P/E ratio (Price to Earnings) has got to be the most commonly used metric when it comes to valuing stocks. The formula is calculated simply by dividing the stock price by the EPS (Earnings Per Share). However, there is no magic number that determines if the stock is a buy or sell, rather different types of investors look for different signals. Value investors typically seek lower P/E ratios as they are interested in buying more earnings power, whereas growth investors are more likely to buy stocks with higher P/E ratios as they believe the earnings growth justifies the higher cost.

Growth investors use the P/E ratio as a building block for pinning down two additional metrics. Substituting the EPS from the last 12 months with the projected EPS over the next fiscal year changes the formula to calculate the forward P/E ratio. Another metric is the PEG ratio which is calculated by dividing the P/E ratio by the company’s expected earnings growth.

A more conservative way to measure a company’s value, is calculating the P/B ratio (Price to Book) which compares the net value (assets minus liabilities) to the market cap. The formula is calculated by dividing a stock’s share price by its book value per share – it is a good indication of what investors are willing to pay for each dollar or a company’s net value. Value investors prefer P/B ratios far below 1, as a market value below book value could turn into a profitable trading opportunity when the market changes its perception.

FCF (Free Cash Flow) is the cash generated by a company minus the cost of expenditures. If a company has rising FCF, it could be due to sales growth, cost reductions, or a combination. In other words, rising free cash flows can be an early indicator to value investors that earnings may increase in the future, which is why many investors cherish free cash flow as a measure of value.

There are many more metrics to assess the value of stocks, but these are some the basics that every investor should know how to use.

Qualitative ways to value stocks

Investing is a world of numbers, but digits are not the only things that matter when evaluating a company. Qualitative factors are harder to quantify and perhaps more prone to subjective meaning, however they cannot be ignored because of it.

For example, it’s important to look into the core business model of a company to find out how it generates revenue and if that is a sustainable approach in the long run. Assess the quality of management by going through the performance history of top executives – if key figures have prior experience in the industry, perhaps they have built and sold a successful business before, that generally bodes well for the company you are evaluating.

Then it’s time to dig deeper into the customer segments and geographic exposure of the company. Does the business rely on selling to a few big customers or many small customers? Are they focused on niche markets in specific areas or do they cover many segments across regions? Are there any regulatory aspects in relation to the territories they operate in?

But of course, no company operates in a vacuum. You need to look at the competition to find out what the competitive advantage is of the business – if there is something they do particularly well in a way that others can’t emulate easily. What about the industry at large? Are there trends the company is playing into or is perhaps ahead of? Every industry has its own experts producing trend analyses which help you determine whether the business is in line with the trend or lagging behind the curve.

Applying these principles to valuing Bitcoin

This is where things get tricky. Bitcoin is not stock in a company. There are no earnings, no cash flow, no management, nor is there competition the same way two companies compete for customers.

Along the quantitative route, you could look at the ‘cost of producing’ Bitcoin, delving into the changing dynamics of mining Bitcoin. As the algorithm only allows for one block to be mined every 10 minutes or so, the more miners join the competition the more difficult it becomes, making it more expensive to ‘produce’ Bitcoin which in turn affects the price as research has shown. Or perhaps it serves to evaluate the performance of the underlying technology by measuring the hash rate – the unit of processing power of the Bitcoin network. Supply and demand play into the price as well, which is why halving events tend to affect the price of Bitcoin on a macro level.

Clearly, these qualitative factors do not explain the price movements of Bitcoin to a satisfying degree. That could arguably explain why many traders prefer to conduct technical analysis to determine entry and exit positions within different time frames, similar to forex trading. There are many trading indicators that serve to develop trade ideas for day traders, as well as long-term approaches to trading BTC. However, technical analysis does tend to fall short when it comes to taking a broad view. No Bollinger Bands signal in 2014 would have indicated the price range of BTC we are in today.

For that reason, the qualitative component of valuing Bitcoin certainly plays an essential role. How does it stack up to competing coins (BCH, BSV)? Does the cryptographic security hold up in the face of evolving technology (think: quantum computing in 20 years) Does Bitcoin play into current trends or is it lagging behind what the world is going to demand more of in the near future?

Perhaps the most important question is simply what role Bitcoin has and what it is used for. It started out as a currency, but as the price surged and other, often better, crypto alternatives hit the market specifically designed for payments, BTC has evolved into an asset used to store wealth, with safe haven qualities much like gold – but perhaps more sophisticated.

It could very well be that BTC takes over from gold as the modern version of a safe haven asset that bears minimal correlation to stock markets. Many financial institutions are now allocating portions of their portfolios to Bitcoin, and many other companies are said to keep parts of their cash reserves in BTC simply to combat inflation – which depreciates their cash reserves.

Or, fast forward another decade, and Bitcoin could take on an entirely new meaning, serving more like an index fund that symbolizes the value of the entire crypto industry at large. While an S&P index fund has actual holdings in companies listed on US stock exchanges and Bitcoin does not ‘hold other currencies’, the S&P 500 is considered an indication of the US economy and in a similar fashion Bitcoin could become an asset that represents market sentiment towards the crypto industry. In that scenario, if you think the crypto industry is looking at continued growth going forward, you would buy Bitcoin.

The real lesson

All in all, there is no clear cut way to evaluate the price of Bitcoin. Quantitative factors combined with technical analysis could help to determine entry and exit positions on shorter time frames, whereas qualitative factors serve to develop a broader view of where Bitcoin can and will go in the future.

In that sense, there is no huge difference to valuing stocks – yes, there are more industry-accepted formulas but all they do is provide suggestions, there is no absolute answer to buy or sell a stock once you know the forward P/E Ratio. It also bears resemblance to forex trading where technical analyses plays a big role, combined with some fundamental analyses that considers the economy tied to a currency. But if BTC does take over further from gold as a safe haven, the context around Bitcoin – meaning global market uncertainties and rising inflation – will only play a larger role in funnelling capital towards BTC.

If you thought one blog article could provide all the answers on such a complicated topic, then you’re not really looking to expand your knowledge and understanding. You’d be looking for shortcuts. There are no shortcuts. Apply the principles of valuing stocks to determine your own position on Bitcoin and reduce the noise of FOMO fomenting media, read analytical reports and BTC research papers to strengthen or change your views, and then execute your own trading idea with precision, dedication, and discipline.

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