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The Stock-to-flow model as a valuation method for Bitcoin

Author: Leonardo Malighetti

Since the historical maximum of Bitcoin in December 2017, its price has been subjected to heavy corrections and price swings, bottoming at slightly more than $ 3,000 during what was then called the “crypto winter” in December 2018. After that, it has been consolidating in a very wide range, moving in not very predictable trends. So far in the year, the price stabilized in a tight range above $ 9,000 after the huge dip during the peak of the COVID pandemic in Europe during March, but without breaking the critical level of $ 10,000. The breaking of this resistance, which will eventually become the next most important support for Bitcoin, is paramount for starting the next and long overdue bull run. In fact, according to the majority of analysts and institutional investors operating inside the crypto world, the sideways trend of Bitcoin lasting more than two years set the base for a big upward movement which will allow the quotation of the first crypto to reach whole new but very uncertain levels. In the hyped context in which Bitcoin peaked, long-term predictions and forecasts on its future price were just speculative and naïve statements and as the events unfolded, almost all of them proved to be wrong. Furthermore, the opinions on the fundamental value of Bitcoin diverge and the crypto itself can be considered in different ways leading to different predictions of its value and under this light, a consensus regarding the future price of Bitcoin seems impossible to achieve. But, since January 2009 when the genesis block (the first mined block of bitcoin) was created, Bitcoin from being worth almost nothing has become a market which is now worth more than 160 billion $ and observing the decennial movement of the crypto coin, there is only one model which almost always faithfully predicted Bitcoin value in the past. The model values Bitcoin using its scarcity and is called Stock-to-flow (S2F).

The stock-to-flow is a ratio computed by dividing the current supply of Bitcoin, the stock, by its new supply, the flow (SF = stock / flow). The stock is the amount of bitcoin already circulating because already extracted by the miners from the blockchain, the existing stockpiles. The flow is the yearly production of Bitcoins, the new supply through which new bitcoins are created by an algorithm of the blockchain which will increase the stock. Intuitively, the S2F metric is the number of years that at the current production growing at a predefined rate it would take to produce the existing stock. Every time the miners add a new block of transactions to the blockchain, new bitcoins are created and awarded to them in a fixed number called “block reward”. This fixed supply of coins works as a compensation mechanism for the miners.

Every time 210,000 blocks are mined in approximately a period of four years the block reward is halved. This peculiarity of the Bitcoin blockchain diminishes the flow of new coins released, lowering the new supply. Therefore, the S2F ratio increases, signifying an increased scarcity of Bitcoin as after a halving, it would take more to extract the same stock than before. The decreasing rate of supply growth of Bitcoin, also called monetary inflation, is stepped and not smooth because of the halving and it will culminate in a total supply of slightly less than 21 million bitcoins when all bitcoins will be extracted from the blockchain.

As it is for precious metals, which are unforgeable and scarce since not easily and quickly supplied and hence valuable, Bitcoin is also valuable. It follows that they have a high SF ratio (or as someone uses, a low supply growth rate (flow/stock and thus SF = 1 / supply growth rate)): for example, gold has a SF of 62 and silver of 22. The opposite stands for consumable commodities, which have a low stock-to-flow (high supply growth rate). Furthermore, Bitcoin has also the unique characteristic of being digital and as Nakamoto wrote: “… and one special, magical property: it can be transported over a communications channel”. Today, the S2F ratio for Bitcoin is: 18.435.256 BTC (circulating supply) divided by the yearly production post-halving of bitcoins, amounting to 328,500 (144 blocks on average x 6.25 bitcoins as block reward x 365 = 328,500). Hence, the S2F of Bitcoin as of July 17th amounts to approximately 56, against a pre-halving ratio of almost 28: it means that bitcoin became even more scarce after the halving (the S2F metric doubled). These features of bitcoin blockchain forge the real value of the coin.

On these premises, a statistical study on the Stock-to-flow model tries to find a significant relationship between the stock-to-flow and the market value of bitcoin with the hypothesis that scarcity (indicated by the S2F metric) directly drives value. Analyzing the data and developing the statistical model, it is true that bitcoin market value tends to be higher when the SF is higher and there is a significant relationship between the variables as showed by the linear relationship in the scatter plot below.

The scarcity is the dominant driving factor of Bitcoin value according to the model, even if other factors impact the valuation (such as regulation, hacks…) and that is why R2 is not 1. The result of the statistical study is reinforced by the fact that gold and silver are in line with the model of bitcoin value for S2F and since they are completely different markets, this adds extra confidence in the model. Beyond this fact, there seems to be a power law relationship, according to which the market value of Bitcoin increases by a constant factor of 10 when the S2F doubles, that is after every halving. This is another result adding further confidence to the model for which the price of Bitcoin is correctly estimated by the S2F model.

The model can’t be statistically rejected because of a lack of statistical evidence and therefore, even if its validity is thoroughly debated, the S2F still holds unless future events will eventually disprove it.

According to the Stock-to-flow model, the May 2020 halving should have driven the bitcoin total market value to 1 trillion $, that is a price of $ 55,000 for one Bitcoin. As for the moment, the supporters of the model nervously look for the awaited upward jump in price as this is what the model predicts. But for now, the 2020 post-halving period, except for some bullish signs, did not bring the hoped bull run of the major crypto coin and Bitcoin so far this year has been greatly outperformed by some major altcoins. In case of failure by Bitcoin to jump from its current level in the second part of the year, the doubts on the validity of the S2F model would be confirmed and there would be greater room to refuse the hypothesis of the model.

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