More and more investors are interested in bitcoin, as confirmed by the recent price rally. Compared to prices a year ago, the crypto asset has increased more than tenfold and doubled since the beginning of the year.

While bitcoin owners are happy about these prices, financial analysts, econometrician, and value investors are still having a hard time valuing bitcoin as well as other cryptocurrencies. With bitcoin there is no interest or cash flow generated, making it difficult to apply quantitative valuation models.

Pascal Hügli is the chief research officer at Schlossberg & Co, in Switzerland, an accredited lecturer at HWZ and CCFE, and author of the book “Ignore at Your Own Risk: The New Decentralized World of Bitcoin and Blockchain.”

In search of a valuation model

By now there are numerous approaches. Probably the most controversial attempt was launched by a Twitter user going by the name of PlanB. His model is based on the so-called stock-to-flow ratio. This measures the relationship between the existing supply (stock) of any commodity – gold, silver, platinum, oil and bitcoin – and its annual production (flow). 

As such, the stock-to-flow ratio is primarily an economic concept. It was used by PlanB to model bitcoin’s price trajectory to be able to make statements about future price developments. After criticism, the pseudonymous financial analyst doubled down and published an adapted version of his stock-to-flow model. With price predictions of up to $288,000 by the end of 2024, he told bitcoiners exactly what they wanted to hear. 

But even his adjustments failed to convince critics. They insisted his model was flawed and incoherent. Others believed they had made the model more coherent and thus more convincing by adding their own revisions. But the debate about whether there is any merit in applying the stock-to-flow model to bitcoin remains highly cloudy.

Tautology of money

One is tempted to ask: What predictive power does the stock-to-flow ratio have? Monetary theory at least, where the stock-to-flow concept originated, is clear on one thing: The ratio measures the "hardness" and thus suitability of a thing as (commodity) money. This is because (commodity) money is by definition the most marketable good and therefore has the highest exchangeability. 

The term “commodity money” was originally introduced by the Austrian-American libertarian monetary economist Ludwig von Mises in his monumental work “The Theory of Money and Credit,” where he distinguishes it from two other forms of money: credit and token money.

Another monetary economist, a Hungarian-Canadian named Antal Fekete, expanded on von Mises’ ideas and described money as having the lowest marginal utility compared to any other good. Thus, one is happy about every additional unit of money, while one feels saturated with other goods at some point. As Fekete argued, the reason for this is the high marketability of money, which is universally exchangeable against all other goods.

So, the more marketable and thus exchangeable a thing is, the more worthwhile it is to hold on to it. But this has us run into the tautology of money: a good is hoarded because it is easily exchangeable and it is easily exchangeable because it has high hoardability. 

In monetary theory, there are prominent attempts to resolve this circular argument, starting with von Mises himself. In practice, it is always paradoxical market processes that resolve such contradictions. In reflexive situations, where investors impact the assets they’re focused on, cause and effect fuel each other. 

Scarcity is relative

The hoardability of money is thus expressed in a high stock-to-flow ratio, as large quantities of it are hoarded and relatively few new units enter circulation. The "perfect" commodity money also shows increasing marginal costs in production. This means the more of it one wants to produce, the more cost-intensive marginal production becomes. This circumstance is often described by the term “scarcity.”

A high stock-to-flow ratio can be translated into everyday language as follows: Due to a high stock, i.e., inventory, it can be assumed that all units of a good ever created are potentially still available somewhere. This is because the good is unlikely to be consumed or used up, but any stock is potential supply (see gold). At the same time, the flow can only be expanded with difficulty due to rising marginal costs in production.

Based on this, we can conclude goods with a high stock-to-flow ratio are only relatively scarce. Absolute scarcity does not actually exist. This is because scarcity is always determined by the relationship between supply and demand, i.e., stocks to flows. 

Supply or selling volume, in turn, results from new production (flow) and existing stocks (stock). If scarcity prevails, supply and demand are not in "equilibrium." The stock of the commodity (money) in question is heavily hoarded and not brought onto markets for whatever reason. Because the flow component can hardly be influenced by trying to produce more, hardly any flow can be added to the market through new production, and so balance the "scarcity." This translates into hardness that is typical of any good with a high stock-to-flow ratio.

In that sense, a high stock-to-flow ratio is a necessary but not sufficient condition for (commodity) money. Also, a high stock-to-flow ratio is a necessary characteristic for a good to serve as hard money. At the same time, however, the ratio says nothing about how market participants value the good in question. 

Inapplicable by definition

But what does the above have to do with bitcoin? Bitcoin's high stock-to-flow ratio is indicative of its hardness as money. Due to its high divisibility, uniformity, durability, transportability and "scarcity," the crypto-asset also possesses characteristics that make it suitable as (commodity) money. It is these characteristic facts about the crypto asset that are currently making people discover bitcoin as money-like.

This discovery process may still be far from complete. The more people discover bitcoin as a monetary alternative, the higher the price is likely to rise. However, by definition, it’s impossible for the stock-to-flow model, in whatever version, to correctly predict future price developments based on past data points. Past results can never be translated into future returns with absolute certainty.

Ultimately, this is probably not the intention behind such models rightly understood. Rather, they serve to give investors (hopeful) indications. It can also be assumed the model will be confirmed here and there in the sense of a self-fulfilling prophecy, as the past correlation shows.

Stability comes after monetization

The following will be interesting to observe: In monetary theory, a high stock-to-flow ratio should gradually translate into low volatility. A convergence in hoarding means the market depth of bitcoin (stocks) will have grown to a considerable size compared to new (in-)flows. 

Due to high stocks, the probability is higher, with other conditions remaining the same, that negative supply shocks or positive demand shocks can be offset in price. Potential supply in the form of stock can leave the hoards at any time and have a stabilizing effect on the price.

Oil and gold provide an example as well as a counterexample. The stock-to-flow ratio of crude oil is very low, hence the large price fluctuations when supply-side disruption occurs. For gold, on the other hand, the high stock-to-flow ratio has a price-damping effect. 

For bitcoin, this could mean concretely. Once its monetization phase following an S-shaped adoption curve is "completed," the bitcoin price should thus also become less volatile due to the steadily growing stock-to-flow ratio.

So does bitcoin's high stock-to-flow ratio prophecy price stability in the long run? A thorough understanding of monetary theory and its concepts would suggest that will happen.

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