Bitcoin and the Stock-to-Flow (S2F) Model
Table of Contents
- Stock-to-flow models are a measure of new supply relative to existing supply.
- Investors use Bitcoin’s stock-to-flow ratio to estimate future prices of the currency.
- Unlike many other assets, Bitcoin’s new supply is constant regardless of the price of the asset.
The Stock-to-Flow Model
The stock-to-flow model is a commonly referenced metric which indicates the new supply of an asset that is being created, relative to the existing supply. This ratio is generally expressed as the annual percentage-based increase in supply, or as the number of years required to double the supply based on the current production rate.
This model is most relevant for assets that derive much of their value from scarcity. Gold markets rely heavily on the stock-to-flow of the asset to determine its fair market value.
Stock-to-Flow and Asset Price
Calculating the fair market value for assets that do not have cash flows is a unique form of analysis. If the supply of the asset is fairly predictable, investors can estimate the future equilibrium price based on the demand. However, the price of the asset itself can also affect the new supply of the asset, disrupting the calculation.
For example, the price of an ounce of gold is roughly $2,000. At that price, there are many companies operating profitable gold mining operations who will continue mining new gold and adding to the supply. If the price of gold were to increase to $10,000 per ounce, the profit from mining gold would increase dramatically. This would create incentives for existing companies to mine gold at a quicker rate and new companies to begin mining operations. The increased energy dedicated to mining gold will increase the supply, which results in a lower equilibrium price.
The ability of markets to regulate supply based on the price of the asset will have a stabilizing effect on the spot price of the asset. This makes it difficult for the price to increase rapidly, because in the long-term the supply of the asset can be increased drastically, with new supply meeting some of the new demand.
Stock-to-Flow and Bitcoin
Bitcoin’s annual supply increase is roughly 1.7% in 2021, just above gold’s rate of 1.6%. Unlike gold, Bitcoin’s rate of increase will decrease forever, eventually reaching 0 once Bitcoin’s hard cap of 21 million bitcoin is reached.
In the short-term, Bitcoin’s new supply from block subsidies is very consistent, so the relative rate of supply increase is declining slowly, due to an increase in the existing supply. Additionally, the block subsidy is halved every 4 years, drastically reducing the amount of new Bitcoin that is being created.
Bitcoin’s new supply does not change as a result of changes in price. As Bitcoin’s price appreciates, more resources will be dedicated to mining the currency. However, the Bitcoin network regulates the difficulty of mining new blocks, ensuring that the rate of new supply is consistent.
The difficulty adjustment means that the rate of new supply cannot be altered to meet demand. Even if the demand of Bitcoin increases drastically, there will be no additional supply to meet this new demand. The extremely consistent monetary policy of Bitcoin allows the asset’s price to increase drastically when there are increases in demand, especially when large portions of the mined supply are held by people who do not wish to sell.
Stock-to-flow models aimed at predicting the price of Bitcoin generally have a target price that is an exponential factor of the stock-to-flow of Bitcoin. This results in price targets that indicate returns well above what investors can expect from typical investments. The market as a whole has not accepted these models. If they had, there would be significantly more investment into Bitcoin and the price would rise such that stock-to-flow predictions would have similar returns to other investments.
Although the stock-to-flow model can be matched fairly well to historical Bitcoin prices, investors cannot expect it to serve as a single indicator for future prices. However, the model does provide a standardized measure of scarcity, which can be used to compare Bitcoin to other scarce assets. Additionally, the model highlights the extreme stability of Bitcoin’s monetary policy.