We are in the middle of earnings season, yet it seems like the main thing investors are talking about these days is not the stock market, but Bitcoin.
This is understandable, given that Bitcoin’s price has increased by around 400% in the last 12 months.
The cryptocurrency has been gaining steam with companies, with Square and Tesla being two examples of companies that recently announced large purchases of Bitcoin.
Even the popular online investment advisory portal, The Motley Fool, announced last week that it will be buying US$5 million of Bitcoin with its own balance sheet.
But is it really a good investment?
First off, how much is Bitcoin actually worth?
Assets are usually valued based on a discount to the future cash flow it can produce.
For example, a property’s value is based on its future rental income, while stocks are valued on their future free cash flows to shareholders. Although stock and real estate prices may fluctuate (sometimes irrationally), they eventually tend to gravitate towards their intrinsic value that is based on their future cash flows.
Bitcoin, however, does not produce any cash flow. And despite the revolutionary blockchain technology backing Bitcoin, it also offers very little utility to most people (unless you are trying to make illegal purchases or live in a country with an unstable currency). This is unlike actual useful things like real estate or even commodities which can be valued based on their utility. As such, valuing Bitcoin is a lot more tricky.
Unsurprisingly, there are numerous opinions on how much Bitcoin should be worth. Some believe that the total value of Bitcoin should be similar to that of gold, while others argue that Bitcoin should be valued based on the value of transactions made using Bitcoin.
But as we have seen since its founding, Bitcoin’s price has not been based on either of these. Instead, Bitcoin’s price is based solely on speculation and has no anchoring toward any form of valuation method.
Lacking any fundamental way to value Bitcoin, the price of Bitcoin at any point in time will simply be how much the average market buyer is willing to pay for a Bitcoin and how much a seller is willing to sell it at.
All of which is based purely on overall market sentiment at the time.
So.. what is driving the price now?
The influx in demand for Bitcoin, and ultimately the price of Bitcoin has been fueled by more investors believing it will go up in price.
This is possibly in some part due to endorsements from influential people in the business and investing world, such as Cathie Wood from Ark Investments, Elon Musk of Tesla (NASDAQ: TSLA), Jack Dorsey of Square (NYSE: SQ), and The Motley Fool.
These influential figures have put their support behind Bitcoin, leading to other investors scrambling to get in on the act, thinking that it will continue to rise in price.
Can it continue?
The question now is whether Bitcoin’s price will continue to rise or will we see it fall back down to pre-2020 levels. We’ve already seen how a swing in sentiment in 2017 led to a massive decline in Bitcoin’s price.
To answer this, we will need to assess current and possible future investor sentiment.
From what I am reading online, it seems that the positive sentiment toward Bitcoin is still going strong.
The endorsement of Bitcoin by so many respected investors and entrepreneurs have resulted in Bitcoin investors having even greater conviction.
As such, many Bitcoin owners are increasingly willing to see out the innate price volatility associated with the cryptocurrency market and continue to hold on to their stake in Bitcoin (They call it Hodl- hold on for dear life).
In addition, investors who have yet to buy may be increasingly getting FOMO (fear of missing out) and may be willing to pay a higher price simply to get in on the action.
But that’s not to say that Bitcoin is without risk. As Bitcoin’s price seems to be based almost solely on sentiment, its price can fall as quickly as it rose.
One event that can crush sentiment toward Bitcoin is regulation. Regulators were quick to respond when Facebook announced that it planned on launching an asset-back cryptocurrency called Libra in 2019 (the cryptocurrency’s name has since been changed to Diem).
If regulators do come in to control the way Bitcoin is transacted, Bitcoin investors may get cold feet.
Similarly, if a new “shinier” cryptocurrency enters the market that is more energy-efficient or transaction friendly, Bitcoin’s popularity may wane.
We should also not underestimate the influence that respected figures such as Elon Musk has over Bitcoin’s price. Should Musk decide to sell Tesla’s Bitcoins, the feel-good factor towards Bitcoin may fall just as fast as it rose.
Bottom line
The bottom line is that Bitcoin has very limited utility currently, and produces no cash flow to holders. Given the absence of a true intrinsic value anchor, Bitcoin’s price will fluctuate based only on market sentiment.
Investing in Bitcoin can be rewarding if more investors hop onto the bandwagon, driving the price up. But if sentiment wanes, investors left holding the bag may end up with big losses.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia owns shares in Tesla and Square.
