Warren Buffett recently made headlines when he said, regarding Bitcoin and cryptocurrencies in general, “I can say almost with certainty that they will come to a bad ending."

But will they? And why would he say that?

To figure out what’s going on (and what’s going on more broadly with the price of Bitcoin and other cryptocurrencies), it’s worth figuring out how to calculate the value of any financial asset.

We recently analyzed the cryptocurrency phenomenon through an accounting lens, but now we will analyze Bitcoin's value through a financial lens.

Finance traditionally defines value as the present value of all future discounted cash flows. What does that mean? It means we should attempt to determine all times, into the infinite future, that an investment will provide us with a cash return, then discount all of those cash flows back to the present. That’s the value of that investment.

Traditionally, finance professionals compare that value with the current price of the investment – if the price is lower, then the investment can be said to have a positive NPV (or net present value) and is worth doing. If not, the NPV is negative, and the investment should be avoided.

This is often done for business projects (such as building a factory to produce a new line of goods, which will produce positive cash flows when they are sold), but it can be performed for financial assets as well.  For example, let’s take a look at the valuation of a stock.

If we purchase a stock at price P0, hold it for one year, and then sell it for price P1, then the value of that stock today will be the future selling price, plus any dividends (payments from the company to stockholders) we will receive, discounted back to today. We compare that value against P0 and decide if we want to buy the stock.

In other words, buy if:

Graphic of innovation types; width: 10px; align: right;

where r is the discount rate and D1 is the dividend to be received next year.

Of course, that assumes that someone will want to buy the stock next year, which they should only do if they think its value is higher than its price (in other words, if the discounted sum of P2 and D2 are greater than P1).  If we continue this exercise forever, we find that the value of a stock is equal to only the present value of its stream of dividend payments, using the growing perpetuity formula. This is called the dividend discount model.

Graphic of innovation types; width: 10px; align: right;

where g is the annual growth rate.

Even for a stock that currently provides no dividends (for example, Google), it can be valued based on the assumption that eventually it will do so, no matter how far into the future that may be (it can be discounted back).

So what is the value of Bitcoin? Well, it will never pay a dividend, so the dividend discount model would suggest that its value is $0. Alternatively, we could consider it a commodity, such as gold, in which its value is based on an inherent value (gold’s inherent value is its utility as a metal, plus its utility as decoration, increased by its rarity), but Bitcoin doesn’t have any inherent value in this way, so its value should be $0. 

We could value it as a currency, but the value of currency is its ability to be used as a store of value or to be exchanged for goods and services – specifically, for fiat currency (currency whose value is not based on another asset such as gold), whether it can be used to pay taxes to the issuing government. Bitcoin can’t effectively be used for either purpose – so its value as a currency is $0 (in fairness, it probably retains a bit of value as a currency for its unique utility in purchasing illegal goods, but I’m not quite prepared in this blog post to assign value for that purpose).

So why, then, is Bitcoin valued so highly by the market?

Well, it’s being driven largely by the discounted value of P1 – the expected price next year. Investors in Bitcoin believe that it will go up in value and they will be able to sell it later for a higher price. But if it’s worth $0 now and will be worth $0 next year, who would pay a higher price?

Leading with Finance - Gain an intuitive understanding of finance. Learn more.

In finance, this is called the greater fool theory. In other words, investors buy an asset today, knowing that this decision is foolish, because they are paying more than the value of the investment. However, they hope that – in the future – they will be able to sell it at a higher price to someone who is being even more foolish than they are – the greater fool.

What motivates people to do this? A variety of terms have been suggested – John Maynard Keynes liked the term animal spirits to describe this sort of irrational behavior, and, more recently, Patrick McGinnis used the term “Fear of Missing Out.” Regardless of the reason, however, the greater fool theory is not a sound theory of investment.

Eventually, any investment based on the greater fool theory must return to its inherent value – in this case, something closer to $0. Which is why Buffett is so confident that Bitcoin will, eventually, come to a bad ending.

Brian Misamore

About the Author

Brian is a former member of Harvard Business School Online's Course Delivery Team and was the lead content developer for Leading with Finance and Management Essentials. He is a veteran of the United States submarine force and has a background in the insurance industry. He holds an MBA from McGill University in Montreal.