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What is the Stock to Flow model?

Introduction

In a word, the Stock to Flow (SF or S2F) model is a way to measure the abundance of a particular resource. The Stock to Flow Ratio is the amount of resources held in reserve divided by the amount of resources produced annually.

What is the Stock to Flow model? foxcbt.com
What is the Stock to Flow model?

The Stock to Flow model is often applied to natural resources. Let’s take the example of gold. Although estimates may vary, the World Gold Council estimates that around 190,000 tons of gold have ever been mined. This quantity (i.e. total supply) is what we might call the stock. Meanwhile, about 2,500-3,200 tons of gold are mined each year. This amount is what we might call the flow.

We can calculate the Stock to Cash Flow ratio using these two metrics. But what does it really mean? Basically, it shows the amount supplied to the market each year for a given resource relative to the total supply. The higher the Supply to Flow ratio, the less new supply entering the market relative to the total supply. Therefore, in theory, an asset with a higher Stock-to-Flow ratio should retain its value over the long term.

In contrast, consumer and industrial goods will typically have a low Inventory-to-Flow ratio. Why so? Since their value often comes from their destruction or consumption, inventory is usually just there to meet demand. These resources are not necessarily as high-value as assets, so they tend to underperform as investment assets. In some exceptional cases, prices can rise rapidly if future shortages are anticipated, but otherwise, production keeps up with demand.

It is important to note that scarcity does not necessarily mean that a resource has to be valuable. For example, gold is not uncommon – after all, there are 190,000 tons available! The Stock-to-Flow ratio shows that it has value because the annual output relative to stock availability is relatively small and constant.

What is the Stock to Flow ratio of gold?

Historically, gold has been the precious metal with the highest turnover rate of any precious metal. But how much is it exactly? Going back to our previous example – let’s divide the total supply of 190,000 tons by 3,200 and we get a Stock to Flow ratio of ~59 . This tells us that at the current production rate, it will take about 59 years to mine 190,000 tons of gold.

However, it should be noted that the estimate of the amount of new gold that will be mined each year is an estimate only. If we increase the annual production (flow) to 3,500, the Inventory to Flow ratio drops to ~54.

While we’re at it, why not calculate the total value of all the gold that has been mined? In some ways, this can be compared to the market capitalization of cryptocurrencies. If we take the price of about $1500 per ounce of gold, the total value of all gold comes to about $9 trillion. This may sound like a lot, but actually, if you combine it all into one block, you can fit that block into a football stadium!

In comparison, the total peak value of the Bitcoin network was around $300 billion at the end of 2017 and is hovering around $120 billion at press time.

Stock to Flow and Bitcoin

If you understand how Bitcoin works, it shouldn’t be hard for you to see why applying the Stock to Flow model to it might make sense. Essentially, the bitcoin processing model is equivalent to scarce commodities, like gold or silver.

Gold and silver are often referred to as storehouses of valuable resources. In theory, they should hold their value in the long run due to their relative scarcity and low flow. Moreover, it is difficult to significantly increase their supply in a short time.

According to proponents of the Stock to Flow model, Bitcoin is a similar resource. It is scarce, relatively expensive to produce, and its maximum supply is 21 million coins. In addition, the release of Bitcoin’s supply is determined at the protocol level, which makes the flow completely predictable. You may also have heard of the Bitcoin halving, where the amount of new supply entering the system is halved every 210,000 blocks (about four years).

According to the proponents of this model, these properties combine to create a scarce digital resource with deeply compelling characteristics to retain value over the long term. In addition, they assume that there is a statistically significant relationship between Stocks and Market Flow and Value. As predicted by the model, the Bitcoin price will increase significantly over time as the Stock-to-Flow ratio continues to decrease.

Among others, the application of the Stock to Flow model to Bitcoin is often attributed to PlanB and his paper on Modeling Bitcoin’s Value with Scarcity.

What is the Stock to Flow ratio of Bitcoin?

The current circulating supply of Bitcoin is around 18 million bitcoins, while the new supply is around 0.7 million per year. At the time of writing, Bitcoin’s stock-to-flow ratio is hovering around 25. After the next halving in May 2020, the ratio should rise to a low of 50.

In the image below you can see the historical relationship of the 365-day moving average of Bitcoin Stocks with Flow to its price. We have also shown the Bitcoin halving date on the vertical axis.

Limitations of the Stock to Flow model

While Stock to Flow is an interesting model for measuring scarcity, it doesn’t take into account all parts of the picture, just as strong as their assumption. For one thing, Stock to Flow is based on the assumption that scarcity, as measured by the model, drives value. According to critics of Stock to Flow, this model will fail if Bitcoin doesn’t have any useful qualities other than a scarcity of supply.

Gold’s scarcity, liquidity, and predictable global flows have made it a relatively stable store of value compared to depreciating currencies such as fiat currencies.

According to this model, the volatility of Bitcoin will also decrease over time. Historical data from Coinmetric confirmed this.

Valuing an asset requires taking its volatility into account. If volatility is predictable to some extent, then the pricing model can be more reliable. However, Bitcoin is famous for its large price fluctuations.

While volatility can be reduced at a macro level, Bitcoin has been priced in the free market since its inception. This means that prices are mostly self-corrected on the open market by users, traders, and speculators. Combine that with relatively low liquidity and Bitcoin is more susceptible to sudden fluctuations than other assets. So the model might not account for this either.

Other external factors, such as an economic Black Swan event, can also weaken this pattern. Although it is worth noting that the same applies to any model that attempts to predict the price of an asset based on historical data. Black Swan events, by definition, have an element of surprise. Historical data cannot account for unspecified events.

Closing thoughts

The Stock to Flow model measures the relationship between the available resource and its production rate. It is commonly applied to precious metals and other commodities, but some argue that it could also apply to Bitcoin.

In this sense, Bitcoin can be seen as a scarce digital resource. According to this method of analysis, Bitcoin’s unique propositions will make it an asset that holds value long term.

However, every model is as strong as its assumptions and it may not take into account all aspects of Bitcoin valuation. Furthermore, at the time of writing, Bitcoin has only been around for a little over ten years. Some might argue that long-term pricing models like Stock to Flow need a larger data set for more reliable accuracy.

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