The Curious Case of Microstrategy ($MSTR)

In the interests of full disclosure, I should note that I’m short some Microstrategy (though not aggressively so) via written long-dated calls.

This is far from a takedown piece. It’s not even really a detailed analysis. And it’s certainly not investment advice. I’m just pointing out some conceptual issues that I don’t hear discussed with regard to Microstrategy ($MSTR).

Let’s start the discussion by looking at the work of a few Nobel Prize Winners in Economics. This is a never a great place to start when considering practical financial market matters, I will admit, but indulge me for a moment.

First we will take a quick look at the work of James Tobin (Nobel 1981).

James Tobin's work directly relates to the valuation of companies by providing a framework for assessing how a company's market value should align with the value of its underlying assets. Tobin's q ratio is calculated as the market value of a company's assets divided by the replacement cost of those assets. Tobin’s q ratio will be greater than 1 when the market values the company’s assets more highly than their replacement cost, and it will be less than 1 when the market values the company’s assets below their replacement cost (because of pessimism about the company’s growth or profitability).

A practical restatement of Tobin’s q ratio as it relates to valuation is that the value of a firm’s equity should equal its book value (assets minus liabilities) plus the present discounted value of its abnormal earnings power.

In an economic sense, abnormal earnings (also called economic profit or residual income) refers to profits that exceed the required return on a company’s invested capital. These earnings are "abnormal" because they go beyond what would typically be expected given the company’s risk level and the opportunity cost of capital.

In Tobin q terms, a company whose business it is to buy and store bitcoin should trade at either no premium to book value, or a small premium if it is able to spin a story about how holding bitcoin will enable it to earn abnormal profits in the future.

Buying and storing bitcoin should not be a source of abnormal earnings. Anyone can do it! It’s about the far from Michael Porter’s Five Forces as you can get. If buying and storing bitcoin were a legitimate source of abnormal earnings power, then every company on the planet should be doing it.

The current ratio of Microstrategy’s market capitalization to value of its bitcoin holdings is 2.73, meaning that investors are paying a premium of 173% for MSTR’s bitcoin holdings. This premium reflects investors optimism about MSTR’s future earnings power. The fact that it’s done well on its bitcoin holdings in the past is irrelevant.

Since a corporate should be valued as an infinitely lived asset, any comprehensive consideration of Microstrategy should consider how it will convert btc to cash in the far future. Currently, Microstrategy bids up its own book by frequently engaging in frantic purchases of more bitcoin. In valuing MSTR, it is necessary to contemplate a far future where they either convert bitcoin to cash, or distribute bitcoin directly to shareholders (which is probably not legally permissible, and would only occur if the MSTR premium were zero or negative).

Is it good or bad to have accumulated a very large stockpile of an illiquid asset? This is not a straightforward question and its core to the Microstrategy valuation. It could be very good.

Current estimates are that Microstrategy holds 252,220 bitcoin. That’s 1.2% of the 21 million that will ultimately be produced, or 1.27% of the 19.869 million bitcoin that are currently outstanding. There are some portion of the btc supply that is permanently lost (to death, lost passwords, etc) and there’s some portion that’s permanently locked up for other reasons.

MSTR is probably far from triggering regulatory interest at the moment, but the speed of accumulation means that it might have trouble in the future. The /BTC futures contract is very active on the CBOE. You can’t, for example, attempt to buy a significant portion of the world’s copper or platinum without regulatory attention.

The bullish case for holding a lot of bitcoin is that no other individual company can replicate your position. This, in itself, is not a great reason for investors to pay a premium for your shares. New companies could spring up that bought and stored smaller quantities of btc, and investors could just buy larger percentages of those companies. In theory, the premium should not exist because starting a company to buy and store bitcoin is not hard. For large btc holdings to be a competitive advantage, there needs to be a reason why being the biggest btc holder is a big competitive advantage for other businesses. It’s been suggested that the biggest btc holder could be a btc bank, for example, but there’s never been a coherent story as to what that looks like.

The bearish case for holding a lot of bitcoin is that, if you ever do start selling, you will be frontrun and you’ll drive the value of your position down significantly.

Going way back to the 1985 Nobel, we should also consider the Modigliani-Miller Theorem. The Modigliani-Miller Theorem states that, under the assumption of no taxes, no bankruptcy costs, and efficient markets, the value of a firm is unaffected by its capital structure—that is, by the way it is financed through a mix of debt and equity. According to the theorem’s first proposition, a firm's overall value remains constant regardless of its financing choices, while the second proposition asserts that increasing leverage raises the cost of equity because of the higher financial risk borne by equity holders.

A practical restatement of the Modiglini-Miller Theorem, the value of the firm (determined its underlying assets and by its ability to generate future cash flows) determines the size of the pie, and you cannot increase the size of the pie by changing the way you slice it into debt and equity.

Financial engineering is not a competitive advantage that investors should pay a premium for because it is easily replicated by other companies.

What you have with Microstrategy is an absurd circularity that is not likely to persist. The circularity is that, because investors are willing to overpay for shares, the company is able to engage in financial engineering that does not generate any true economic value but seems good in the short term. The entire valuation story rests on the presumed ability to sell shares at a high premium relative the btc holdings per share.