How to value crypto by cost of production: Introducing P/P
By: Vikram Arun
Tags: Investing, Blockchain, Research, Cryptocurrency, Bitcoin

Disclaimer: This article is not meant as investment advice. Use it to supplement your own thoughts and analysis.

This article is a continuation of developing fundamental ways to value crypto, as outlined here and here. The four main ways we have to value crypto right now are from its use as a currency, stock, product, or network. This will address valuation from the product perspective.

Everything costs less to mine than to buy them on the market. We wouldn’t have miners otherwise. What are the implications? Let’s find out. We also introduce a ratio we use at Ledger to think about this.

Introduction

To understand the value behind a digital asset, we need to figure out how we get them in the first place. We can get them in the following ways:

1. On an exchange (with fiat currency or another token)

2. From another person (say, in exchange for a coffee)

3. By producing them ourselves (mining)

Viewing the source of digital assets as #1 or #2 lends to valuing them as a currency or network. #3 is where the production model comes in.

Adam Hayes first introduced this model to try and figure out how valuable this mining process was. For those of you not familiar with mining, it’s essentially a huge computational and energy intensive effort to maintain the integrity of a token’s PoW (Proof-of-Work) consensus algorithm, which is needed to verify the blockchain. I’m not going to get into depth on the process behind mining, but if you want to get more this is a good article. At the very least, viewing the inputs of electricity and energy as tangible monetary value should represent a token’s worth.

If we were miners, we would mine a coin as long as the market value of it is greater than the cost for us to do it. Given a perfectly competitive & efficient market, in theory, the monetary value of said coin should drift to whatever the cost of mining is at that time. Let’s consider this to be the base value of a coin, which can then be given by the following formula:

Fundamental Production Cost Equation

Background

Now that we have our fundamental relationship, let’s dive into the numerator and denominator of the term to better understand where they come from. We will scale the terms of the equation daily to make it easier to compute.

1) The numerator: Energy Cost

The total cost of the energy used, put in terms of daily output, can be expressed as follows:

ϵ = Energy Efficiency (W per Hs) and ρ = Hash Power (H/s)

The Hash Power, ρ, is going to be dependent on the coin we are mining. But we can estimate values for both $/kWh and ϵ, Energy Efficiency. Let’s start by figuring out what a reasonable estimate for the price of electricity, the $/kWh term, would be.

a) Cost of electricity ($/kWh)

It’s not just the cost of electricity that plays into a miner’s decision to choose a location — internet speeds and a low temperature environment to reduce cooling costs are equally as important. Given the specifications for mining and the fact that it occurs in so many different countries with different electricity costs, how do we estimate this? Luckily, a great study conducted in 2017 by Judge Business School at the University of Cambridge, among many other things, mapped out mining facilities across the globe. Check it out.