The cryptocurrency market is currently in a phase of rapid expansion, yet it remains relatively nascent in terms of its overall maturity. Investors and traders, intrigued by the potential of this emerging asset class, have been seeking robust long-term valuation models to ascertain appropriate price levels for cryptocurrencies, particularly Bitcoin, which stands as the pioneer of the digital currency movement. Central to these inquiries is the question of whether Bitcoin's price will continue to ascend over time, driven by its inherent scarcity. In this exploration, we delve into a quantitative model known as the stock-to-flow model, which measures Bitcoin's value by considering its scarcity, and analyze its potential to forecast Bitcoin's price over an extended time horizon. Along the way, we will unravel the intricacies of this model, compare the stock-to-flow ratios of Bitcoin and gold, investigate the stock-to-flow model's mechanics for Bitcoin price prediction, and address the nuanced challenges that may impede its accuracy in predicting Bitcoin's future price trends.
Understanding the Stock-to-Flow Model
At its core, the stock-to-flow model is an investment framework that evaluates an asset's current stock in relation to its rate of production, typically measured as the total amount produced over the course of a year. This model serves as a comparative metric, allowing analysts to assess the relative abundance or scarcity of a particular resource. The underlying premise is straightforward: the scarcer a resource, the better it functions as a store of value, retaining its worth and purchasing power over time. While this principle has traditionally been applied to assess the scarcity of natural resources, such as precious metals (e.g., gold, silver, platinum), it has found new relevance in the context of digital assets like Bitcoin.
Historically, assets like real estate, stocks, and bonds have also functioned as stores of value, but Bitcoin represents a unique case in the realm of digital scarcity. The advent of Bitcoin, which features a capped supply of 21 million coins and an open-source, decentralized network, led to the adaptation of the stock-to-flow model for the cryptocurrency. Valuing Bitcoin through this model began with the work of a pseudonymous author known as PlanB.
In PlanB's article, "Modeling Bitcoin Value with Scarcity," the author elucidates how the stock-to-flow model can be aptly applied to Bitcoin by highlighting the statistically significant relationship between the cryptocurrency's circulating scarcity and its influence on price. PlanB argues that Bitcoin possesses the quality of "unforgeable costliness" – a concept that is pivotal to the model. To mine and create new Bitcoins, substantial quantities of electricity must be expended, entailing considerable monetary costs. This unique feature, PlanB contends, places Bitcoin in the category of scarce assets that can be comparatively assessed using the stock-to-flow model. This is a departure from traditional fiat currencies, which can be created at will by centralized authorities, resulting in a lack of scarcity and the theoretical availability of an unlimited supply. In contrast, Bitcoin's existing supply exceeds 18 million coins, out of a capped circulating supply of 21 million that will be fully mined by 2140.
When Bitcoin Becomes Increasingly Scarce
The protocol underlying Bitcoin's operation is designed to ensure that no additional Bitcoins will be mined or created once the predetermined limit of 21 million coins is reached. The system operates on the basis of a predetermined and transparent issuance schedule, governed by open-source code. Crucially, Bitcoin's rate of production decreases over time. Specifically, every 210,000 blocks, which translates to approximately every four years, the network undergoes a halving process. This event leads to a reduction in the amount of Bitcoin rewarded to miners for validating a block, effectively cutting their rewards in half. Consequently, the production of new Bitcoins decreases with each successive halving, and this phenomenon has a direct and immediate impact on the Bitcoin ecosystem.
As a result of these halving events, the stock-to-flow ratio of Bitcoin increases with each occurrence, rendering the cryptocurrency an even scarcer resource. The scarcity of Bitcoin is integral to its allure as an asset with the potential for long-term value preservation and appreciation.
Calculating the Stock-to-Flow Ratio
The stock-to-flow ratio is a fundamental concept within the stock-to-flow model and is calculated by dividing the current stock (i.e., the quantity of the resource already in existence) by the flow (i.e., the quantity of the resource produced in the next 12 months). In the case of Bitcoin, the stock represents the total number of Bitcoins that have been mined up to the present, while the flow corresponds to the quantity of Bitcoin expected to be mined over the upcoming year.
One of Bitcoin's unique characteristics, owing to its open-source nature, is the transparency of its code. This transparency allows anyone with coding proficiency to access information regarding the cryptocurrency's supply. Consequently, the current stock of Bitcoin can be readily determined. Additionally, the rate and volume of new Bitcoin production are well-defined. For instance, as of the fall of 2021, over 18 million Bitcoins had been mined. Given that the average time required to produce a new block in the Bitcoin blockchain is approximately 10 minutes, miners receive a reward of 6.25 BTC for adding a new block of transactions to the blockchain. Consequently, every 10 minutes, 6.25 BTC are created. This equates to 37.5 BTC produced per hour (6.25/10 minutes × 60 minutes/hour) and a daily production of 900 BTC (37.5/hour x 24 hours/day). Hence, the annual flow of Bitcoin, at that time, amounted to 328,725 BTC (900/day x 365.25 days per year). In essence, this flow is indicative of the quantity of Bitcoin expected to be mined in the next 12 months.
At the time of this assessment, the circulating supply of Bitcoin stood at 18.8 million, with a flow of 0.33 million Bitcoins (328,725 ÷ 1,000,000). This calculation yielded a current stock-to-flow ratio for Bitcoin of 57, underscoring the increasing scarcity of the cryptocurrency.
Decreased Flow Due to Bitcoin Halving
One of the critical factors that contribute to Bitcoin's scarcity and augment its stock-to-flow ratio is the periodic halving of rewards for miners. Currently, miners receive 6.25 bitcoins as a reward for mining each block. However, with the upcoming halving event, slated for 2024, this reward will be reduced to 3.125 BTC. This signifies a 50% reduction in the rate of new Bitcoin production.
This reduction in the flow component of the stock-to-flow ratio has a profound impact on the overall ratio. When the denominator of a ratio (in this case, the flow) is decreased, it invariably increases the resulting value of the ratio. Consequently, Bitcoin's stock-to-flow ratio is anticipated to witness a significant surge during the next halving event in 2024, potentially reaching a ratio of nearly 120.
What Happens if the Ratio Is Low?
A low stock-to-flow ratio signifies that a resource has a high level of new production relative to its existing stock. This condition suggests that the resource is susceptible to inflation, wherein the value of the resource tends to depreciate as a result of the abundance of new production. When a product is excessively inflated, its price tends to decline significantly.
Fortunately for Bitcoin, its stock-to-flow ratio is unlikely to diminish. This is primarily attributable to the fact that while the numerator of the ratio (the stock) continues to increase each year, the denominator (the flow) decreases every four years due to the halving events. Consequently, the resulting stock-to-flow ratio consistently rises, affirming Bitcoin's increasing scarcity and its role as a potential store of value.
Gold vs. Bitcoin Stock-to-Flow Models: The Differences
Comparing the stock-to-flow ratios of gold and Bitcoin unveils several fundamental distinctions between the two:
- Current SF Ratios: The current stock-to-flow ratio for gold is approximately 62, with a known gold stock of 185,000 tons and an annual new gold flow of 3,000 tons. Conversely, Bitcoin's stock-to-flow ratio, as previously established, was around 57 at the time of assessment.
- Historical Fluctuations: A noteworthy distinction lies in the historical fluctuation of the stock-to-flow ratio. Over the past century, gold's stock-to-flow ratio has oscillated between 45 and 90. These variations are largely attributed to changes in gold production rates based on market conditions.
- Predictable Bitcoin Halving: In contrast, Bitcoin's issuance schedule is systematic and predetermined. Every four years, the production of new Bitcoin is cut in half through halving events, resulting in an accelerated increase in Bitcoin's stock-to-flow ratio. The next Bitcoin halving is anticipated in 2024, which will further elevate the SF ratio to approximately 120, reflecting heightened scarcity.
Using the Bitcoin Stock-to-Flow Model for Price Prediction
PlanB's research, which centers on Bitcoin's stock-to-flow ratio, involved conducting a regression analysis that juxtaposed Bitcoin's price history against the model's insights. In essence, this analysis sought to identify any correlation between Bitcoin's price movements and the stock-to-flow model.
The results of PlanB's research yielded intriguing findings. It was discovered that Bitcoin's price closely adhered to a formula that incorporated Bitcoin's stock-to-flow ratio. The formula for the model price of Bitcoin is expressed as follows:
Model Price (USD): e^(-1.84) × SF^3.3
Upon scrutinizing this formula, it becomes evident that the stock-to-flow ratio is the sole variable involved, with the letter 'e' representing Euler's number. In practical terms, this ratio experiences a gradual increase on a daily basis as new Bitcoin is added to the existing stock. It is this incremental growth in the daily stock-to-flow ratio that propels the model price of Bitcoin upward. Furthermore, with each halving event, the stock-to-flow ratio undergoes a significant surge, leading to an appreciable jump in the model price of Bitcoin.
Analyzing the Model Price and Actual Bitcoin Price
To gain a comprehensive understanding of how well the model aligns with Bitcoin's historical price movements, it is instructive to visualize the data. The chart below showcases the model price formula smoothed by applying a 463-day simple moving average:
The chart depicts the relationship between the model price and the actual price of Bitcoin since its inception. Notably, in the early stages of Bitcoin's existence, there were limited trading opportunities and substantial difficulties in acquiring the cryptocurrency. Over time, an array of cryptocurrency exchanges emerged, facilitating easier access to Bitcoin trading.
One of the striking observations when reviewing this chart is that Bitcoin's price does not precisely mimic the model's trajectory. Instead, there are instances when the price exceeds the model's predictions, resulting in price overshoots. Conversely, there are periods during which the price falls below the model's projected value, leading to price undershoots. This variation can be a source of insight for traders, enabling them to gauge whether Bitcoin is currently overvalued or undervalued relative to its modeled price.
As of the most recent assessment, the model suggests that Bitcoin's price should be approximately $107,000. However, at that time, Bitcoin was trading at around $62,000, which is nearly half of the model's indicated price. This substantial discrepancy raises questions among traders and analysts, prompting some to consider Bitcoin as potentially undervalued and inexpensive.
To further aid in the assessment of Bitcoin's valuation relative to the model, the chart incorporates an orange line that illustrates the actual price deviation from the model price. When the orange line resides above the green line, it signifies that the actual price exceeds the model price, implying that Bitcoin is overperforming in terms of valuation. Conversely, when the orange line falls below the green line, it indicates that the actual price is underperforming relative to the model's predictions.
This comparative analysis enables traders and investors to gauge whether Bitcoin is currently overvalued or undervalued based on its deviation from the model price. Such insights can be valuable for making informed investment decisions in the cryptocurrency market.
Challenges and Limitations of the Bitcoin Stock-to-Flow Model
While the stock-to-flow model has demonstrated considerable efficacy in elucidating Bitcoin's historical price dynamics and emphasizing the reasons for its elevated valuation compared to a decade ago, it is essential to critically assess the model's potential limitations. To gain a more comprehensive perspective, we must explore some of the potential challenges that could erode the model's efficacy as a reliable predictor of Bitcoin's future price behavior.
Problem 1: Demand for Bitcoin
A fundamental consideration pertains to the demand dynamics of Bitcoin. While the scarcity resulting from its issuance schedule plays a pivotal role in driving price appreciation, it is crucial to recognize that demand remains a critical factor in determining the value of the Bitcoin network.
It is noteworthy that several blockchain platforms, such as Litecoin and Cardano, share structural similarities with Bitcoin, including capped supplies and diminishing production schedules. However, these blockchains' native currencies do not exhibit price patterns that align with the predictions of the stock-to-flow model. The reason for this disparity lies in the variance in demand. Demand for Bitcoin significantly outstrips that of other blockchain networks, which results in a higher valuation. Therefore, it follows that if events transpired that adversely affected the demand for Bitcoin, its value could decouple from the valuation model based on stock-to-flow.
Problem 2: Gold's Stock-to-Flow Doesn't Drive Its Price
Another critical consideration emerges from the observation that, in the case of gold, the stock-to-flow ratio does not exert a dominant influence on its price movements. Gold's price fluctuations are influenced by multifaceted factors that extend beyond the scope of the stock-to-flow ratio. Although Bitcoin's periodic halving events and subsequent increases in stock-to-flow are intuitively appealing as explanations for dramatic price surges, the same rationale does not necessarily apply to gold.
In fact, real-world historical data indicates that the price of gold remains uncorrelated with its stock-to-flow ratio. To illustrate this point, we can draw upon Voima's findings, which highlight that the price of gold displays a lack of correlation with its stock-to-flow ratio over an extended time frame.
Problem 3: SF Ratio Doesn't Explain Price for Other Cryptos
While the stock-to-flow ratio has been influential in explaining Bitcoin's price dynamics, its applicability does not extend uniformly to other cryptocurrencies. Bitcoin Cash and Litecoin, for example, are cryptocurrencies that share many characteristics with Bitcoin, including capped supplies and diminishing production rates. Despite these similarities, these cryptocurrencies do not attain the same valuations as Bitcoin.
This divergence in valuation underscores the notion that the stock-to-flow ratio is not the exclusive or dominant driver of a cryptocurrency's value. Other complex and multifaceted factors contribute to the valuation of digital assets, highlighting the limitations of extrapolating the success of the stock-to-flow model from Bitcoin to other cryptocurrencies.
Problem 4: Exponential Growth in Buying Power Required
One of the inherent challenges facing Bitcoin's ability to perpetually align with the stock-to-flow model is the necessity for exponential growth in demand. The model suggests that Bitcoin's price experiences an order of magnitude increase with each halving event, implying that there must be a continuous and exponential surge in demand to sustain this pattern.
Drawing from analogies in the business world, we can consider the example of social media giant Facebook. Facebook experienced a period of exponential growth, where new users and advertisers flocked to the platform. However, this growth eventually reached a saturation point, where sustaining exponential expansion became increasingly difficult.
Similarly, Bitcoin may encounter a point at which exponential growth in demand is no longer sustainable, especially as the majority of potential investors and institutions have already entered the market. Currently, there exists a substantial pool of individuals and institutions who have yet to invest in Bitcoin, making it relatively easy to attract new participants into the network. However, as this pool diminishes, the capacity for Bitcoin to maintain exponential growth in demand becomes constrained.
For instance, consider the case of MicroStrategy, a publicly-traded company that adopted Bitcoin as a component of its treasury strategy. While stories like MicroStrategy's are likely to become more prevalent, there will eventually come a time when fewer institutions opt to integrate Bitcoin into their treasury plans. This decline in institutional demand has the potential to decouple Bitcoin from the stock-to-flow model.
The current stock-to-flow ratios for Bitcoin underscore its increasing rarity and suggest that the cryptocurrency is potentially undervalued relative to the model price. However, it is essential to approach this valuation methodology with a critical eye, considering both the historical relationship between the stock-to-flow model and Bitcoin's price and the inherent volatility of the cryptocurrency.
The prevailing sentiment is that Bitcoin's valuation through the stock-to-flow model may not be a perpetual certainty. The model's predictive capabilities need to be evaluated alongside historical data and Bitcoin's unique attributes. Consequently, it remains plausible that Bitcoin is gradually decoupling from the model, and the model's validity as a long-term price predictor may be gradually diminishing.
As Bitcoin continues to evolve and adapt to changing market dynamics, it will be essential for investors and analysts to consider a holistic set of factors when assessing its value. The stock-to-flow model, while valuable, should be just one tool in the arsenal of methods for evaluating the future price trajectory of this pioneering digital asset. In the ever-evolving landscape of cryptocurrencies, adaptability and a multifaceted approach to analysis will be key to making informed investment decisions.