Forget Bitcoin, Buy Ether – Winklevoss Bitcoin Trust ETF (Pending:COIN)

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Bitcoin (BTC) just smashed through $5000, is approaching $6000, and is making headlines again. Also, this time Jamie Dimon is refusing to talk about it. You should ignore this price jump, and buy Ether (ETH) instead.

In a previous series of articles I explained how to value Bitcoin (Part I), and what it’s value is (Part II). Unless we get either (1) a speculative bubble, or (2) a major leap in Bitcoin’s technology, I don’t think that BTC warrants higher than a 30% price increase over the next 12 months from, and likely not even that much. Ether, by contrast, is set for another 100% gain. I’m going to explain why, beginning with what the Ethereum network is.

What is Ether?

The Ethereum network flips Bitcoin technology on its head, and that’s why it’s so much better.

To be clear, Bitcoin is a digital currency that works by a blockchain technology. That technology just keeps track of who owns what, i.e., of the global leger of Bitcoin transactions. So the technology powers the coin.

The Ethereum network inverts that idea: the coin powers the technology. The blockchain technology is the Ethereum network, which runs a system of global “smart” contracts (i.e., they are like legal contracts, but are enforced automatically by a computer program). Ether is the coin that powers the Ethereum network; it’s the “gas,” so to speak. Each time the program runs, it requires “gas” to complete a transaction. The more people on the network, the more gas they need to buy, and so the more valuable Ether should be.

(Note: The above paragraph avoids the difference between Ether and Ethereum gas, but the core information is accurate for investing purposes. If you really want to learn about the difference, and maybe like programming, see this video.)

From this perspective, Bitcoin is a “dumb” technology. It uses its massive technological capacity for only one use-case: keeping track of the Bitcoin ledger. The Ethereum network uses its blockchain technology to represent any programmable contracting system. You can program it to represent the S&P 500, or the movements of the US dollar, or a 2x levered price of Apple stock. You can even reproduce Bitcoin within the Ethereum network.

It is this unprecedented generality that forms the heart of the Ethereum network. Effectively, it’s a single blockchain computing system, which is why the creator, Vitalik Butterin, calls it the Ethereum Virtual Machine. Other programs run on it, the way that programs run on the Windows operating system, or apps run on cell-phones. The difference is that apps are run on just one machine (your phone), while Ethereum “apps” are run on a distributed machine (the blockchain). Hence, why they’re called DApps (distributed apps).

Why Ethereum Will Make Money

The advantages to first-movers in setting up an ecosystem are well-known. Think of the way that Microsoft (MSFT) dumped billions to break into the cell-phone market after Apple (AAPL) and Google (GOOG) had already established themselves. My bet is that you do not own a Microsoft powered cell phone, and that’s the point. Those who move first in establishing an ecosystem enjoy an enormous competitive advantage, since new users gain the full usability of the network, as opposed to the very partial usability they would have on a nascent network. App ecosystems, then, are a technological example of the durable comparative advantage that Buffett calls a “moat.”

In fact, the advantages of first movers are so extreme for app ecosystems that extra-ordinary external pressure is needed for more than one to exist at all. Apple, for example, was only able to create a second ecosystem by keeping all of its products internal to its system. And to do that, they had to leverage their already existing userbase of iPod owners; they couldn’t compete from scratch.

No similar conditions exist with the Ethereum network, which is why 98.5% of all other coin DApps are built on it (at present). The only competitor is NEO, which hopes to be the choice of the Chinese regulative authorities, and was built with the peculiarities of Chinese law and regulation in mind. In short, an artificial body, China, might serve to prop-up the NEO network, so that it can function in the cryptocurrency world in the way that the Apple functions with phones. Still, Ether will fuel the applications of the reset of the world, making it the better long-term technology.

The primary good that Ethereum offers, then, is the ability to build other applications on its already established network. Presently, most of those other DApps are other coins-this is where initial coin offerings (ICOs) come from-but other use-cases are already in development. As a result, even if the majority of those ICOs can fail, Ethereum will profit on the winners and losers alike. Buying into Ether is like buying into all the ICOs, without the risks associated with the losses of any one of them individually. Yet, it is also buying into the other use-cases of Ethereum, which are not ICOs, such as its ability to function as a digital currency (just like Bitcoin).

Bitcoin v. Ether

So why is Ether a better buy? Bitcoin, after all, is expected to grow (even if I’m more pessimistic that many about its growth). The answer is that, relative to the value of their underlying networks, Ether is not only a better technology than Bitcoin, it’s cheaper.

For those who want to understand what network value is, and how to use it to value coins, please see the linked articles. I’m going to use a price to Metcalfe value (P/MV) in the following graphs, and the important thing to know is that it functions like a firm’s price to book value (P/BV), so lower is better. One reason this approach works well is because it has accurately identified previous bubbles in Bitcoin and Ether (for the others, read the linked articles).

The following chart shows how Bitcoin’s price, relative to its network value, has increased rather dramatically. I’ve scaled the chart logarithmically; green is for price in US dollars, and orange is the Metcalfe value (=network value) of Bitcoin. I also added a 20-day trend-line (dotted) to smooth things out.

[Data Source: blockchain.info, My Own Chart]

Here’s a look at Ether’s price relative to its network value (again measured by Metcalfe’s Law in orange). Unlike Bitcoin’s case, it looks like Ether’s price has finally dropped below its Metcalfe value. This chart is also scaled logarithmically, green is for the price in US dollars, and I added a (dotted) trend-line.

Data Source: etherscan.io, My Own Chart]

Here’s another look at the same data, without logarithmic scaling. The new blue line charts the Price to Metcalfe value ratio (P/MV), so that you can clearly see it’s decline below one-making Ether historically cheap.

[Data Source: etherscan.io, My Own Chart]

While this chart shows the same story, I think it highlights just how undervalued Ether is. The blue trend line is consistently downward (that’s like a falling Price to Book Value), and the network value of Ether has regularly exceeded its price since the Chinese ICO mess.

The story thus looks like this: Ether is undervalued because people have overblown the negative implications of China’s actions. Bitcoin, by contrast, might be entering a bubble as it probably shouldn’t be worth more than $4000.

We might want to know how much the Ethereum network is likely to grow through 2018. Here are some proposals, based on historical data. Ethereum has had a 1000% increase in daily transactions in 2017 so far, with a dip after China banned ICOs, and a 300% increase the year before. Bitcoin, by contrast, has seen a relevant growth increase this year of only 25%. Since each new ICO (nearly) makes use of the Ethereum network, we’re likely to see another significant growth year in 2018, even if it is not as much as the present year. A modest guess for the end of 2018 might be an 80% increase, but I’ll run scenarios with only a 25% increase. If that’s right, we get the following scenarios, all of which make a 100% price increase by the end of 2018 reasonable.

Nodes

MV

P/MV

US$

% Increase

Present

349605

427.7828

0.697691

298.46

25% Growth

437006.3

668.4106

0.7

467.8874

57%

25% Growth

437006.3

668.4106

1

668.4106

124%

80% Growth

629289

1386.016

0.7

970.2114

225%

100% Growth

699210

1711.131

0.7

1197.792

301%

For comparison, the historical average of Ether’s P/MV is 1.81 (over the most recent period, which excludes former bubbles periods). Only one of the above scenarios even uses a P/MV of 1, so they all assume continued undervaluation through 2018. I’ve tried my best, then, to build in a margin of safety.

Concluding Review

The reason Bitcoin is going up right now is because there is going to be a “friendly” fork, with Bitcoin Gold being delivered to all current Bitcoin (BTC) holders. If you got in a week ago, you could have Bitcoin at $4100, and receive a coin worth probably $410, roughly a 10% gain. After the fork, my guess is that Bitcoin will drop down in price.

Longer term, Bitcoin and Ether are both likely to grow, but Ether is a better deal. This is the case for two reasons:

  1. The Ethereum Network is a better technology with more room for growth.
  2. Ether’s price, relative to the size of its network, is much less than Bitcoin’s.

In short, Ether is both cheaper and better than Bitcoin. So if I had to choose (I do own both), I’d own only Ether.

Look forward to your comments as always!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own some Bitcoin, Ether, and Neo.

Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

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