June 24th, 2024

Economics 101: What is Bitcoin?

By Eric Van Enk on February 25, 2023.

Can Bitcoin be categorized as a financial asset, currency, commodity or ‘other’ and how should it be valued?

Given my background as a chartered financial analyst (CFA) with degrees in finance and economics, I look at everything through the lens of a financial analyst.

One of the key principals of finance is that an asset should be worth the discounted value of its expected cash flow into the future. CFA’s working on Wall Street and Bay Street use complex discounted cash-flow models to calculate target prices for public and private companies.

They forecast how much cash companies will generate in future years and discount that cash flow back to a present value for the stock. Commercial real estate is valued in a similar manner (rent you expect to earn). Bitcoin can’t be valued using this method because it doesn’t generate earnings or cash flow.

Is Bitcoin a currency?

Currencies have value due to a country’s ability to tax its citizens. The stronger a country’s economy, the greater the government’s ability to tax. International currencies are a multi-trillion-dollar, sophisticated market where professional traders around the world buy and sell currencies daily based on the currency’s prospects of appreciating or depreciating in value.

Traders consider factors like interest rates, GDP growth and inflation to determine the value of one currency relative to another (e.g. Canadian vs. U.S. dollar). Digital currencies like Bitcoin can’t be valued like a traditional currency because they don’t represent the tax base of any country.

Is Bitcoin a commodity?

Commodities are products required to produce essential goods – oil, lumber, copper, grains, etc. For example, we need oil to produce plastic, gasoline, paint, fertilizer, etc. Is Bitcoin a required input for anything? Does Bitcoin need to exist?

If digital currencies like Bitcoin aren’t a financial asset (don’t generate cash flow like a stock, bond or real estate) and they aren’t a currency (don’t represent the tax base of a country) and aren’t a commodity (not an essential input; don’t need to exist), what are they?

Are digital currencies a Ponzi scheme?

Not necessarily – assets like art, baseball cards and rare cars don’t fit into the categories outlined above (financial assets, currencies or commodities). Baseball cards don’t need to exist and don’t generate cash flow or represent a country’s ability to tax, yet, they have value.

Assets like baseball cards derive value from scarcity – the rarer the card, the higher the value. They aren’t making any more Van Gogh’s or Monet’s, which creates scarcity value for fine art. It’s in this last category, which I will term ‘other,’ that digital currencies belong in my view.

Digital currencies only have value because someone else is willing to buy them; the day nobody wants to buy them, they will cease to have value. Digital currencies have no inherent value because they don’t generate cash flow, don’t represent any tax base and aren’t a required input for anything.

Investors in digital currencies may want to Google ‘Dutch tulip mania’ for an interesting read.

Eric Van Enk is a wealth adviser & associate portfolio manager with National Bank Financial in Medicine Hat. He is a graduate of the University of Calgary, as well as a CFA charter holder with 20 years of financial markets experience in New York, Toronto and Calgary. He can be reached at eric.vanenk@nbc.ca.

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