Bitcoin is the first scarce digital object the world has ever seen. Like silver or gold its supply is finite – only 21 million coins will ever be in circulation.
Bitcoin’s scarcity adds to its value – which is where the Stock-to-Flow (SF or 2SF) model comes in. The Stock-to-Flow ratio predicts Bitcoin’s value by quantifying its digital scarcity.
Scarcity and Bitcoin
According to Nick Szabo, an American cryptographer and computer scientist, scarcity creates ‘unforgeable costliness’ and provides an asset with inherent value.
Bitcoin’s underlying technology ensures that the supply of new coins reduces over time, increasing scarcity. When a miner calculates the hash number needed to validate a block of transactions, creating a proof-of-work, they receive a ‘block reward.’
The block reward is halved every 210,000 blocks, an event known as ‘Bitcoin halvings.’ The block reward has reduced from 50 Bitcoins in 2009, to 25 BTC in 2012 and 12.5 BTC in 2016 and 6.25 BTC in 2020. The next halving event is scheduled for spring of 2024.
Historically, the Bitcoin halving has triggered the price of Bitcoin to surge exponentially. Given that the price of Bitcoin increases as the rate of supply tightens, investors can use measures of scarcity to find the point of maximum financial opportunity for investment.
What is the Stock-To-Flow model?
The Stock-to-Flow ratio was popularised by a pseudonymous Dutch institutional investor “PlanB.” This model seeks to value Bitcoin in the same way as gold and silver, both ‘store of value’ commodities.
Its basic premise is that scarcity drives value meaning that scarce entities make for stable investments. It is difficult to substantially increase gold’s production since finding gold and then extracting it, is costly and time-consuming. The same principle holds true for Bitcoin.
Stock-to-flow ratios compare a commodity’s existing stock (the total amount available) to the flow of new production (amount mined during a specific year). It can be determined as SF= Stock / Flow, where stock= existing reserves or stockpiles and flow= yearly production.
Application of the Stock-To-Flow Model
According to Coinmarketcap, Bitcoin currently has a stock of 18.68 million coins (88.3% of total supply). When new blocks are mined, this number changes every 10 minutes. At the moment, each new block adds 6.25 Bitcoins to the Blockchain. Bitcoin’s current flow or yearly production is approximately 0.7 million per year, according to Binance.
Imputing these values to the Stock/Flow formula gives 26.68 SF (18.68/0.7). Meanwhile, the current stock of gold= 190,000 tonnes and flow of production= 3000 tonnes per year, gives an SF ratio of 63.33. Silver, which has a stock of 550,000 tonnes and a flow of 25000 tonnes per year, has an SF ratio of 22. This high SF makes gold and silver popular stores of value.
Price has tracked the stock-to-flow ratio of Bitcoin over time, as seen in the graph above. Moreover, Bitcoin halving events make the S2F ratio higher (i.e., scarcity), leading to the rise in Bitcoin’s price. It is the most relevant metric for investors to grasp why Bitcoin is considered a monetary asset rather than just a commodity.
Limitations of the Stock-To-Flow model
Although Stock-to-Flow is a useful model for calculating scarcity, it does not consider all aspects of the valuation. For one thing, it ignores the volatility metric, which is vital for valuing an asset. Therefore, this valuation model becomes more accurate if the volatility of an asset is stable to some degree. Bitcoin, on the other hand, is known for its substantial price swings.
Nonetheless, as Bitcoin’s price has traditionally followed the S2F ratio, it is a useful metric to forecast future Bitcoin valuations.