The cryptocurrency fever is reminding many in the investing community that a clear distinction must be made between the concepts of investment and speculation. Ben Graham provided a useful definition of investing as “an …. operation which, upon thorough analysis, promises safety of principal and a satisfactory return.” Graham’s definition provides an important insight for the current market environment. For an asset to provide “safety of principal”, or what Graham called a “margin of safety”, an investor must purchase the asset at a price which is significantly below the asset’s intrinsic value.
How should an investor calculate an asset’s intrinsic value? Valuation literature often references three methods of calculating value: the replacement cost approach, the comparables approach, and the income approach. However, the income approach is the only theoretically reliable method of value calculation (but can be supplemented by the other methods). An investor should view the intrinsic value of an asset as the present value of the asset’s future income stream. As a simple example, consider the value of a loan which will pay $500 each year for two years. At the end of two years, the loan will mature and the principal amount of $10,000 will be repaid to the loan holder. What would an investor seeking to earn 10% on her investment pay for this loan? The investor would calculate the present value of the asset’s income stream ($500 in year 1, and $10,500 in year 2) as follows:
($500 ÷ (1+.10)1) + ($10,500 ÷ (1+.10)2) = $9132.24
In other words, this asset has an intrinsic value of $9,132 based on the investor’s required return of 10%. While this example is overly simplified, the same concept of value holds for calculating the intrinsic value of any income producing asset, such as a stock, bond, or commercial real estate.
Now, herein lies the crucial point. Implied in Graham’s definition of investing, you can only invest in an asset which you can value. And you can only calculate an asset’s value when you can estimate its future income stream. The implications for cryptocurrencies should be clear: how do you establish a value for bitcoin or any other cryptocurrency? I should also note that the concept of “supply and demand”, which is so often referenced by cryptocurrency enthusiasts, is a driver of price (particularly in the short-term) but has no use in estimating value.
I am, personally, agnostic about cryptocurrencies. I only mean to imply cryptocurrencies should, at the very least, be thought of as speculative assets, much like gold.