NYU's 'Dean Of Valuation': Bitcoin's Not A Fraud, It's A Currency

Aswath Damodaran, a professor of finance at the NYU's Stern School of Business, disagrees with JPMorgan Chase CEO Jamie Dimon that bitcoin is a "fraud," and explains that, in his view, the cryptocurrency is a currency rather than an asset in a new blog post.

Often referred to as Wall Street's "Dean of Valuation," Damodaran concludes:

"I don't believe cryptocurrencies are now or ever will be an asset class," or that they will change the "fundamental truths of risk, investing and management."

Via Musings on Markets blog,

As I have noted with my earlier posts on crypto currencies, in general, and bitcoin, in particular, I find myself disagreeing with both its most virulent critics and its strongest proponents.  Unlike Jamie Dimon, I don't believe that bitcoin is a fraud and that people who are "stupid enough to buy it" will pay a price for that stupidity. Unlike its biggest cheerleaders, I don't believe that crypto currencies are now or ever will be an asset class or that these currencies can change fundamental truths about risk, investing and management. The reason for the divide, though, is that the two sides seem to disagree fundamentally on what bitcoin is, and at  the risk of raising hackles all the way around, I will argue that bitcoin is not an asset, but a currency, and as such, you cannot value it or invest in it. You can only price it and trade it.

Assets, Commodities, Currencies and Collectibles

Not everything can be valued, but almost everything can be priced. To understand the distinction between value and price, let me start by positing that every investment that I will look at has to fall into one of the following four groupings:

1. Cash Generating Asset: An asset generates or is expected to generate cash flows in the future. A business that you own is definitely an asset, as is a claim on the cash flows on that business. Those claims can be either contractually set (bonds or debt), residual (equity or stock) or even contingent (options). What assets share in common is that these cash flows can be valued, and assets with high cash flows and less risk should be valued more than assets with lower cash flows and more risk. At the same time, assets can also be priced, relative to each other, by scaling the price that you pay to a common metric. With stocks, this takes the form of comparing pricing multiples (PE ratio, EV/EBITDA, Price to Book or Value/Sales) across similar companies to form pricing judgments of which stocks are cheap and which ones are expensive.

 

2. Commodity: A commodity derives its value from its use as raw material to meet a fundamental need, whether it be energy, food or shelter. While that value can be estimated by looking at the demand for and supply of the commodity, there are long lag and lead times in both that make that valuation process much more difficult than for an asset. Consequently, commodities tend to be priced, often relative to their own history, with normalized oil, coal wheat or iron ore prices being computed by averaging prices across long cycles.

 

3. Currency: A currency is a medium of exchange that you use to denominate cash flows and is a store of purchasing power, if you choose to not invest. Standing alone, currencies have no cash flows and  cannot be valued, but they can be priced against other currencies. In the long term, currencies that are accepted more widely as a medium of exchange and that hold their purchasing power better over time should see their prices rise, relative to currencies that don't have those characteristics. In the short term, though, other forces including governments trying to manipulate exchange rates can dominate. Using a more conventional currency example, you can see this in a graph of the US $ against seven fiat currencies, where over the long term (1995-2017), you can see the Swiss Franc and the Chinese Yuan increasing in price, relative to the $, and the Mexican Peso, Brazilian Real, Indian Rupee and British Pound, dropping in price, again relative to the $.

 

 

4. Collectible: A collectible has no cash flows and is not a medium of exchange but it can sometimes have aesthetic value (as is the case with a master painting or a sculpture) or an emotional attachment (a baseball card or team jersey). A collectible cannot be valued since it too generates no cash flows but it can be priced, based upon how other people perceive its desirability and the scarcity of the collectible. 

Viewed through this prism, Gold is clearly not a cash flow generating asset, but is it a commodity? Since gold's value has little to do with its utilitarian functions and more to do with its longstanding function as a store of value, especially during crises or when you lose faith in paper currencies, it is more currency than commodity. Real estate is an asset, even if it takes the form of a personal home, because you would have had to pay rental expenses (a cash flow), in its absence. Private equity and hedge funds are forms of investing in assets, currencies, commodities or collectibles, and are not separate asset classes. 

Investing versus Trading

The key is that cash generating assets can be both valued and priced, commodities can be priced much more easily than valued, and currencies and collectibles can only be priced. So what? I have written before about the divide between investing and trading and it is worth revisiting that contrast. To invest in something, you need to assess its value, compare to the price, and then act on that comparison, buying if the price is less than value and selling if it is greater. Trading is a much simpler exercise, where you price something, make a judgment on whether that price will go up or down in the next time period and then make a pricing bet. While you can be successful at either, the skill sets and tool kits that you use are different for investing and trading, and what makes for a good investor is different from the ingredients needed for good trading. The table below captures the difference between trading (the pricing game) and investing (the value game).

As I see it, you can play either the value or pricing game well, but being delusional about the game you are playing, and using the wrong tools or bringing the wrong skill set to that game, is a recipe for disaster.

What is Bitcoin?

The first step towards a serious debate on bitcoin then has to be deciding whether it is an asset, a currency, a commodity or collectible. Bitcoin is not an asset, since it does not generate cash flows standing alone for those who hold it (until you sell it).  It is not a commodity, because it is not raw material that can be used in the production of something useful. The only exception that I can think off is that if it becomes a necessary component of smart contracts, it could take on the role of a commodity; that may be ethereum's saving grace, since it has been marketed less as a currency and more as a smart contracting lubricant.  The choice then becomes whether it is a currency or a collectible, with its supporters tilting towards the former and its detractors the latter. I argued in my last post that Bitcoin is a currency, but it is not a good one yet, insofar as it has only limited acceptance as a medium of exchange and it is too volatile to be a store of value. Looking forward, there are three possible paths that I see for Bitcoin as a currency, from best case to worst case.

1. The Global Digital Currency: In the best case scenario, Bitcoin gains wide acceptance in transactions across the world, becoming a widely used global digital currency. For this to happen, it has to become more stable (relative to other currencies), central banks and governments around the world have to accept its use (or at least not actively try to impede it) and the aura of mystery around it has to fade. If that happens, it could compete with fiat currencies and given the algorithm set limits on its creation, its high price could be justified.

 

2. Gold for Millennials: In this scenario, Bitcoin becomes a haven for those who do not trust central banks, governments and fiat currencies. In short, it takes on the role that gold has, historically, for those who have lost trust in or fear centralized authority. It is interesting that the language of Bitcoin is filled with mining terminology, since it suggests that intentionally or otherwise, the creators of Bitcoin shared this vision. In fact, the hard cap on Bitcoin of 21 million is more compatible with this scenario than the first one. If this scenario unfolds, and Bitcoin shows the same staying power as gold, it will behave like gold does, rising during crises and dropping in more sanguine time periods. 

 

3. The 21st Century Tulip Bulb: In this, the worst case scenario, Bitcoin is like a shooting star, attracting more money as it soars, from those who see it as a source of easy profits, but just as quickly flares out as these traders move on to something new and different (which could be a different and better designed digital currency), leaving Bitcoin holders with memories of what might have been. If this happens, Bitcoin could very well become the equivalent of Tulip Bulbs, a speculative asset that saw its prices soar in the sixteen hundreds in Holland, before collapsing in the aftermath.

I would be lying if I said that I knew which of these scenarios will unfold, but they are all still plausible scenarios. If you are trading in Bitcoin, you may very well not care, since your time horizon may be in minutes and hours, not weeks, months or years. If you have a longer term interest in Bitcoin, though, your focus should be less on the noise of day-to-day price movements and more on advancements on its use as a currency. Note also that you could be a pessimist on Bitcoin and other crypto currencies but be an optimist about the underlying technology, especially block chain, and its potential for disruption.

Reality Checks

Combining the section where I classified investments into assets, commodities, currencies and collectibles with the one where I argued that Bitcoin is a "young" currency allows me to draw the following conclusions:

1. Bitcoin is not an asset class: To those who are carving out a portion of their portfolios for Bitcoin, be clear about why you are doing it. It is not because you want to a diversified portfolio and hold all asset classes, it is because you want to use your trading skills on Bitcoin to supercharge your portfolio returns. Lest you view this as a swipe at cryptocurrencies, I would hasten to add that fiat currencies (like the US dollar, Euro or Yen) are not asset classes either.

 

2. You cannot value Bitcoin, you can only price it: This follows from the acceptance that Bitcoin is a currency, not an asset or a commodity. Any one who claims to value Bitcoin either has a very different definition of value than I do or is just making up stuff as he or she goes along.

 

3. It will be judged as a currency: In the long term, the price that you attach to Bitcoin will depend on how well it will performs as a currency. If it is accepted widely as a medium of exchange and is stable enough to be a store of value, it should command a high price. If it becomes gold-like, a fringe currency that investors flee to during crises, its price will be lower. Worse, if it is a transient currency that loses all purchasing power, as it is replaced by something new and different, it will crash and burn.

 

4. You don't invest in Bitcoin, you trade it: Since you cannot value Bitcoin, you don't have a critical ingredient that you need to be an investor. You can trade Bitcoin and become wealthy doing so, but it is because you are a good trader.

 

5. Good trader ingredients: To be a successful trader in Bitcoin, you need to recognize that moves in its price will have little do with fundamentals, everything to do with mood and momentum and big price shifts can happen on incremental information.

Would I buy Bitcoin at $6,100? No, but not for the reasons that you think. It is not because I believe that it is over valued, since I cannot make that judgment without valuing it and as I noted before, it cannot be valued. It is because I am not and never have been a good trader and, as a consequence, my pricing judgments are suspect.

If you have good trading instincts, you should play the pricing game, as long as you recognize that it is a game, where you can win millions or lose millions, based upon your calls on momentum. If you win millions, I wish you the best! If you lose millions, please don't let paranoia lead you to blame the establishment, banks and governments for why you lost. Come easy, go easy!

*  *  *

As a reminder, CoinDesk reports that back in July, Damodaran also argued that cryptocurrencies were quickly becoming a preferred alternative to gold for people who don't trust traditional fiat currencies.

Comments

VD pods Wed, 10/25/2017 - 12:57 Permalink

as an NYU alum, i can tell u this is yet another idiot NYU prof (there are too many of them there) who cant correctly distinguish between currency and unit of (speculative) payment backed by a basic and already antiquated blockchain. & what legit currency is this volatile, historically speaking? riddle yourselves that and you should appreciate where btc stands. hey, at least he has enough humility to admit he cant value that which is valueless. & he admit he cant trade. but sure as hell can teach and opine. (as the saying goes, those that can't do, teach.)

In reply to by pods

Buckaroo Banzai VD Wed, 10/25/2017 - 14:36 Permalink

Damodaran's analysis is good, except that one of his assumptions is badly wrong, which torpedoes his whole argument.Unlike gold, or dollars, or other currencies, BitCoin doesn't exist in a vaccuum. It is built on a gigantic technological infrastructure, that cost billions of dollars in hardware, software, and energy. It is a global transactional infrastructure that has the opportunity to replace the banking system as we know it today. The BitCoin infrastructure is an asset by definition, because it generates cash flows (both transaction processing fees and blockchain mining rewards) that are denominated in BitCoin.So BitCoin is, in fact, both an asset that produces cash flows AND a currency.

In reply to by VD

VD Buckaroo Banzai Wed, 10/25/2017 - 15:46 Permalink

the average biz produces some good or service, which is of value, or that is the project anyhow. btc does neither. it is speculative monetization in pyramid fashion of basic code. now, you can say that in itself is a kind of service, but, so was Bernie Madoff's operation, until it wasn't. the interesting similarities here are that Madoff was one of the few "investment advisors" ever to be allowed to be his very own primary broker, and btc mimics this too in a sense.the infrastructure of btc is not a business model per se, but, rather, a decentralized experiment in monetization of "coins" off of said basic code. it's basically a decentralized pump and dump scheme, which has decent marketing and novelity branding. and lets not get into corporate structures and shareholders and all that, bc btc does not satisfy any of those parameters either. we can of course try to compare btc to something like paypal, but from the above you can infer how that contrasts too. it is an NSA/Deep State conditioning scheme.

In reply to by Buckaroo Banzai

HRClinton ParkAveFlasher Wed, 10/25/2017 - 16:53 Permalink

Gold is a PRECIOUS COMMODITY.  Precious, yes, but still a Commodity.    > It's a Precious Metal (hence "PM") -- used in Industry, Jewelry and Collectibles (private collectibles and Central Banker collectible).   > It does not generate Cashflow. Unlike a stock, RE, IP or a Business, which usually do generate cashflow.   > In large amounts, it costs fiat money to Transport it, to Insure it and to Store it.  As such, it has NEGATIVE Yield. Amateurs store it at home or hide it elsewhere (X marks the spot).   > It's not a Collectible, because you can invite people to see your Antiques, Art, etc, but not to see your Gold.   > It's a Hedge -- an expensive Insurance Policy -- against a large devalutaion or crash of a country's fiat currency.The Q you have to ask yourself re PM is:  Just how much Insurance/Hedge do I need, and how much am I willing to pay for it?

In reply to by ParkAveFlasher

MEFOBILLS BaBaBouy Wed, 10/25/2017 - 16:04 Permalink

Ah, the old argment about currency.None of these old definitions work anymore.  Currency means to make current, to flow, to circulate.  In the old days, currency was base money.  Base money was at the bottom of the inverted pyramid.  Said inverted pyramid had gold or treasury money at the bottom, then 10:1 credit riding on top.The credit moved on ledgers while the currency was in people's pockets.  Gold was also stored at the bank.Today, bank credit is 97% of the money supply.  It is also called on-accounts.  On-account money fluxes back and forth from ledger to physical notes.  There is no longer any difference.So, any talk about currency reveals to the reader, that "nerdy" professors do not know of what they speak.  On account bank credit decrements one ledger while incrementing another, so in effect the "currency" is moving via ledgers.Also, the argument about asset verses purchasing power.  Asset nature and purchasing power nature of money are at odds with each other.  It is good to purchase assets that are not money and hold them as storing of wealth.This is the key reason bitcoin is being bought.  People are fleeing poorly managed bank money, and buying bit coin as a hedge.  Bitcoin is also useful as a way of avoiding scrutiny by state actors, so it is favored by a criminal element.  You can also purchase things outside of taxes, which is another attractive element to bitcoin.Bitcoin also is scarce, because like gold it is mined.  The mining does not keep up with demand.  Said demand is national bank money as purchasing power, chasing after bitcoins, which bids bitcoin up in price.  Prices are denominated in the national unit, not bitcoins.So, look at the action of the money, not some random definition, especially since hypnotists want you to think a certain way by using words.  And, these words have lost their meaning.Bitcoin has many properties, chief among them is commodity.  Bitcoins have a price just like commodity.  It is not an exchange rate.  Bitcoins are not a legal unit good for paying taxes.  The true nature of money is law.  Bitcoins are not good for paying debts as a legal unit, they must be sold to acquire legal money, to then pay debts.Is bitcoin currency? It does transact and move, so it has some currency function.  But, it moves on a ledger in the same way that bank money does.  Only, the bitcoin ledger is special given the blockchain security.  The ledger security is an ASSET, including the infrastructure.So.. it is mostly commodity, it is not money, it is an asset.  It does not have an exchange rate, but does have a price.  Bitcoins backing is the desire of people to buy it.Go to college, and get hypnotized by professors who know not of what they speak.https://www.sovereignmoney.eu/money-system-theory/

In reply to by BaBaBouy

SeuMadruga ultraticum Wed, 10/25/2017 - 12:58 Permalink

BTC has no value according to the strict sense of that word defined by the author (i.e. a cash generating item), though the absolutely true example you gave fits within the meaning of utility, which it definetively has in abundance. BTW, cryptos is what has been enabling us 3rd worlders to amass a stack/stash abroad of...mind you...GOLD and silver, thanks to Vaultoro.com, Goldmoney.com, BullionStar, etc !

In reply to by ultraticum

AllBentOutOfShape The_Juggernaut Wed, 10/25/2017 - 16:11 Permalink

A currency backed by.......... bankers.Is segwit2x the REAL Banker takeover?https://np.reddit.com/r/btc/comments/743qb8/is_segwit2x_the_real_banker…

  • DCG's Board of Directors and Advisors is almost entirely made up of Central Bankers including one currently sitting Member of the Federal Reserve Bank of New York and another who was Chief Economist at the World Bank.
  • The CEO of the company spearheading the Segwit2x movement (Barry Silbert) is an ex investment banker at Houlihan Lokey. Also, Mastercard is an investor in the company DCG, which Barry Silbert is the CEO of.
  • The company overseeing development on Segwit2x, Bitgo, has a product/service that seems to only have utility if transacting on chain and using 0-Conf is inefficient or unreliable.
  • Segwit2x takes power over Bitcoin development from core, but then literally gives it to central bankers and Mastercard. If segwit2x goes through, BTC development will quite literally be controlled by central bankers and a currently serving member of the Federal Reserve Bank of New York.

In reply to by The_Juggernaut

Son of Captain Nemo Raffie Wed, 10/25/2017 - 12:18 Permalink

"Haters are so cute, they think their argument is valid when cryptos are being globally adopted every day more and more. "

With more careful inspection by the only ones left with real money with a "store of value" that matters in Beijing and Moscow!

Which is why the next and ONLY accepted crypto will be coming from those two nation(s) just mentioned once international rules and standards get written to every device that encrypted packet is sent through to your device as an ACCEPTED "medium of exchange".

In reply to by Raffie

Son of Captain Nemo 11b40 Wed, 10/25/2017 - 13:51 Permalink

Maybe if you stop fucking with them, their neighbor(s) North Korea and business associates in Niger ,they might accommodate your requirements for PHYZ on demand either through a Chinese bank that stores and ships it from over there -BUT ONLY IF .GOV "IS REALLY GOOD"... Or perhaps a neighborhood bank that can facilitate that transaction through them for you!

In reply to by 11b40

Son of Captain Nemo 11b40 Wed, 10/25/2017 - 15:31 Permalink

Maybe you're not directly "fucking" with N Korea but your tax payments certainly are...

As for the problems cashing checks in denominations exceeding $5K. As for Ft. Knox???... Your government appears to be having problems selling it's 10 and 15 year Treasuries because it doesn't pay it's debts with it's creditors...

If you want it to change, my advice is an insurrection when you've been an indifferent "cheerleader" this long and it only keeps getting worse for you!

In reply to by 11b40

Son of Captain Nemo tmosley Wed, 10/25/2017 - 13:55 Permalink

"Be careful what you wish for."

You means the aliased "master of the universe" with the Japanese name that lives in Ft Meade Maryland that doesn't "own itself" any more, and has nothing but a "printing press" with a slogan backing it's currency???

I think it's safe to say that #1 and #2 look mighty inviting for managing money vs. #3 who's sun set a long long time ago!

Parting shot...

You wouldn't be going off "reservation crypto currency agnostic" with that comment now would you tm?... I thought it didn't matter where crypto currency comes from as long as it is accepted by it's users as a medium of exchange and a store of value???... Don't be gettin political on U.S. now brotha!!!

In reply to by tmosley

Son of Captain Nemo tmosley Wed, 10/25/2017 - 15:25 Permalink

"Depends on how you interpret it."

Stay with me tm... Stay focused brotha....

"Medium of exchange" and "store of value" which is the most important... That is if you want that medium of exchange "thing" to work. Neither of which North America has a place at the table "anymore" given it's debt obligations and less places to spend it's money that keeps coming "home" when this happens (https://www.rt.com/business/407704-china-oil-plans-yuan-contract/)....

That leaves the EU to head East which will remove the problems entirely, creating sound crypto currency with the PRC and Russian Federation.

Problem SOLVED!... Unless of course the U.S. has other plans to wreck it (https://www.rt.com/usa/407763-us-aircraft-carriers-pacific/)!...

In which case should they be successful with their Navy... We won't have to worry too much about crypto currency or ANYTHING ELSE for that matter!!!

In reply to by tmosley