This 1 Metric Suggests Bitcoin Is 70% Undervalued -- Should You Buy It?

Putting a valuation on a crypto asset like Bitcoin (CRYPTO: BTC) is harder than it sounds. Traditional valuation methods intended for valuing stocks or other assets simply aren't very useful, as the coin has no cash flows or balance sheet.

But there are a few creative ways to figure out if Bitcoin is overpriced or underpriced that don't rely on a gut feeling or a biased impression of recent price action. In fact, one of those valuation methods suggests that Bitcoin is undervalued by around 70%. Let's take a closer look at what the signal is here and whether it means the coin is worth purchasing.

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Energy costs suggest this asset is cheap right now

As you probably know, Bitcoin is produced by an army of miners. Those miners buy specialized crypto mining hardware, and then operate it, using other inputs like water and electricity along the way to ultimately produce Bitcoins, which the miners can then sell to recoup their costs. Given that the prices of all of these inputs are easily known, it's possible to calculate a ballpark figure for the all-in costs required for a miner to produce a Bitcoin.

From this understanding, it's also possible to estimate the fair value of Bitcoin expressed as a function of the total joules of energy (electricity) expended by miners, in light of the protocol's supply growth rate and a conversion factor that maps energy costs to dollars. In short, more energy committed over time, with all else equal, implies a higher intrinsic value per coin.

One financial model of this dynamic, created by Capriole Investments, suggests that Bitcoin should be priced at around $175,400, as the energy expenses required to mine a single coin are currently on the high side. In the past, the coin's price hasn't strayed too far above or below the value of all the energy required to produce 1 BTC, with deviations between the two typically resolving within 18 months, both to the upside and to the downside. So by Capriole's energy-based valuation methodology, Bitcoin has upside of around 70% or more, as it's currently undervalued. If it behaves like in prior instances of a disconnect between electricity costs and Bitcoin price, this gap won't exist for very long, which suggests that there's an opportunity for those who buy it now.

But there are a few caveats.

Numerous other energy-based valuation methodologies for Bitcoin exist, and they aren't a new approach; some may produce results that disagree with each other as a result of making different assumptions about costs. Furthermore, these models depend on assumptions about average mining hardware efficiency and average electricity costs in the places where mining is performed with the most intensity. So treat these valuations as compasses rather than oracles.

Why price and energy tend to converge in practice

One of the reasons this valuation method is effective is that Bitcoin's mining difficulty self-balances depending on how many miners are participating in the network. The protocol adjusts difficulty every 2,016 blocks to keep average block time near 10 minutes. When the overall mining hash rate falls, mining difficulty then automatically ratchets a bit lower, which reduces the energy required per block and stabilizes miner economics. When hash rate rises, the reverse occurs.

That mechanism links energy input to price through incentives. If price sinks below miners' breakeven level for long enough, weaker operators switch off machines, energy input falls, and the energy value declines toward price. If price rises, more machines come online, the total energy spent climbs, and then it rises toward price.

So, knowing this, is Bitcoin worth buying while it's supposedly on the cheap side? In a word, yes.

This valuation metric points to a good outlook over the next 12 months or so. But beyond that, the picture actually gets better for those who are holding Bitcoin. New issuance drops every halving, which gradually tightens available float. Then, less fresh supply means the same dollar of incremental demand can move price more than before.

While halvings occur about every four years, the takeaway is that accumulating scarce assets when forward supply is shrinking often has a favorable payoff if you can hold through noise. And in Bitcoin's case, the payoff has been quite favorable indeed; its price is up by 502% in the last three years.

Therefore if your investing horizon is years, not weeks, the energy consumption valuation lens strengthens the investment thesis to hold and accumulate this asset. A practical plan is to dollar-cost average (DCA) a fixed amount, then add more on material drawdowns when sentiment is sour.

Alex Carchidi has positions in Bitcoin. The Motley Fool has positions in and recommends Bitcoin. The Motley Fool has a disclosure policy.