MicroStrategy's business model will significantly increase the volatility of BTC prices, acting as an amplifier of fluctuations.
Author: @Web3_Mario
Abstract: Last week we explored the potential for Lido to benefit from changes in the regulatory environment, hoping to help everyone seize this wave of "Buy the rumor" trading opportunities. This week, a very interesting topic is the heat surrounding MicroStrategy, with many predecessors commenting on the company's operational model. After digesting and researching this, I have some of my own views that I would like to share. I believe the reason for MicroStrategy's stock price increase lies in the "Davis Double Play," which ties the appreciation of BTC to the company's profits through a business design that finances the purchase of BTC. This innovative design, which combines traditional financial market financing channels, provides the company with the ability to achieve profit growth that surpasses the appreciation of its BTC holdings. As the position expands, the company gains a certain degree of pricing power over BTC, further reinforcing this profit growth expectation. However, the risk lies in this: when BTC prices experience fluctuations or reversal risks, profit growth from BTC will stagnate. Additionally, due to the company's operating expenses and debt pressure, MicroStrategy's financing ability will be significantly discounted, which will affect profit growth expectations. Unless there is new support to further boost BTC prices, the positive premium of MSTR's stock price relative to its BTC holdings will quickly converge, a process known as the "Davis Double Kill."
What is the Davis Double Play and Double Kill
Friends familiar with my work should know that I am dedicated to helping more non-financial professionals understand these dynamics, so I will replay my thought process. Therefore, I will first supplement some basic knowledge about what "Davis Double Play" and "Double Kill" are.
The so-called "Davis Double Play" was proposed by investment master Clifford Davis and is typically used to describe the phenomenon where a company's stock price rises significantly due to two factors in a favorable economic environment. These two factors are:
Company profit growth: The company achieves strong profit growth, or optimizations in its business model, management, etc., lead to increased profits.
Valuation expansion: Due to the market's more optimistic outlook on the company, investors are willing to pay a higher price, thus driving up the stock's valuation. In other words, the stock's price-to-earnings ratio (P/E Ratio) and other valuation multiples expand.
The specific logic driving the "Davis Double Play" is as follows: first, the company's performance exceeds expectations, with both revenue and profits growing. For example, strong product sales, expanded market share, or successful cost control will directly lead to profit growth. This growth will also enhance market confidence in the company's future prospects, leading investors to accept a higher P/E ratio and pay a higher price for the stock, causing the valuation to begin expanding. This linear and exponential combined positive feedback effect usually results in accelerated stock price increases, known as the "Davis Double Play."
To illustrate this process, suppose a company's current P/E ratio is 15 times, and its future profits are expected to grow by 30%. If, due to the company's profit growth and changes in market sentiment, investors are willing to pay an 18 times P/E ratio, then even if the profit growth rate remains unchanged, the increase in valuation will drive the stock price up significantly, for example:
Current stock price: $100
Profit growth of 30% means earnings per share (EPS) increase from $5 to $6.5.
P/E ratio increases from 15 to 18.
New stock price: $6.5 × 18 = $117
The stock price rises from $100 to $117, reflecting the dual effects of profit growth and valuation increase.
On the other hand, the "Davis Double Kill" describes a rapid decline in stock prices due to the combined effects of two negative factors. These two negative factors are:
Company profit decline: The company's profitability decreases, possibly due to reduced revenue, increased costs, management errors, etc., leading to profits falling below market expectations.
Valuation contraction: Due to profit declines or worsening market prospects, investor confidence in the company's future decreases, leading to a decline in its valuation multiples (such as P/E ratio) and a drop in stock prices.
The entire logic is as follows: first, the company fails to meet expected profit targets or faces operational difficulties, leading to poor performance and profit declines. This further worsens market expectations for its future, causing investor confidence to wane, and they are unwilling to accept the currently high valuation multiples, only willing to pay lower prices for the stock, resulting in a decline in valuation multiples and further drops in stock prices.
To illustrate this process, suppose a company's current P/E ratio is 15 times, and its future profits are expected to decline by 20%. Due to the profit decline, the market begins to doubt the company's prospects, and investors start to lower its P/E ratio. For example, reducing the P/E ratio from 15 to 12. The stock price may thus drop significantly, for example:
Current stock price: $100
Profit decline of 20% means EPS decreases from $5 to $4.
P/E ratio decreases from 15 to 12.
New stock price: $4 × 12 = $48
The stock price drops from $100 to $48, reflecting the dual effects of profit decline and valuation contraction.
This resonance effect usually occurs in high-growth stocks, especially in many technology stocks, as investors are often willing to assign high expectations for future growth to these companies. However, such expectations are often supported by significant subjective factors, leading to considerable volatility.
How MSTR's High Premium is Created and Why It Becomes the Core of Its Business Model
With this background knowledge supplemented, I believe everyone should have a general understanding of how MSTR's high premium relative to its BTC holdings is generated. First, MicroStrategy has shifted its business from traditional software to financing the purchase of BTC, and future asset management revenue cannot be ruled out. This means that the company's profit source comes from capital gains on BTC purchased with funds obtained through equity dilution and bond issuance. As BTC appreciates, all investors' equity will correspondingly increase, benefiting investors, which makes MSTR similar to other BTC ETFs in this regard.
The distinction lies in the leverage effect brought by its financing ability, as MSTR investors' expectations for future profit growth stem from the leverage gains obtained from its financing capabilities. Considering that MSTR's total market value is in a positive premium state relative to the total value of its BTC holdings, this means that MSTR's total market value exceeds the total value of its BTC holdings. As long as it remains in this positive premium state, whether through equity financing or convertible bond financing, the funds obtained will be used to purchase BTC, further increasing the equity per share. This gives MSTR a profit growth capability that differs from BTC ETFs.
To illustrate, suppose MSTR currently holds $40 billion in BTC, with total outstanding shares X and total market value Y. At this point, the equity per share is $40 billion / X. In the worst-case scenario of equity dilution for financing, suppose the new share issuance ratio is a, which means the total outstanding shares become X * (a + 1). If financing is completed at the current valuation, a total of a * Y billion dollars will be raised. If all these funds are converted into BTC, the BTC holdings will increase to $40 billion + a * Y billion, meaning the equity per share becomes:
We will subtract this from the original equity per share to calculate the growth of equity per share due to diluted shares, as follows:
This means that when Y is greater than $40 billion, which is the value of its BTC holdings, it indicates the existence of a positive premium. Completing financing to purchase BTC will result in a growth in equity per share that is always greater than 0, and the larger the positive premium, the higher the growth in equity per share, which is a linear relationship. As for the impact of the dilution ratio a, it presents an inverse proportional characteristic in the first quadrant, meaning that the fewer shares issued, the higher the growth in equity.
Therefore, for Michael Saylor, the positive premium of MSTR's market value relative to the value of its BTC holdings is the core factor for the establishment of its business model. Thus, his optimal choice is how to maintain this premium while continuously financing, increasing his market share, and gaining more pricing power over BTC. The continuous enhancement of pricing power will further boost investor confidence in future growth even at high P/E ratios, enabling him to complete fundraising.
In summary, the secret of MicroStrategy's business model lies in the appreciation of BTC driving the company's profit increase, and a positive growth trend in BTC implies a positive growth trend in corporate profits. Supported by this "Davis Double Play," MSTR's positive premium begins to amplify, so the market is betting on how high a positive premium valuation MicroStrategy can achieve for subsequent financing.
What Risks Does MicroStrategy Bring to the Industry
Next, let's discuss the risks that MicroStrategy brings to the industry. I believe the core issue is that this business model will significantly increase the volatility of BTC prices, acting as an amplifier of fluctuations. The reason lies in the "Davis Double Kill," and the period when BTC enters a high-level fluctuation phase is the beginning of the entire domino effect.
Let us imagine that when BTC's price increase slows down and enters a fluctuation period, MicroStrategy's profits will inevitably begin to decline. Here, I want to elaborate on this point, as I see some friends placing great importance on its holding costs and unrealized gains. This is meaningless because, in MicroStrategy's business model, profits are transparent and equivalent to real-time settlement. In the traditional stock market, we know that the factors that truly cause stock price fluctuations are financial reports. Only when quarterly financial reports are released can the market confirm the actual profit levels. In the meantime, investors can only estimate changes in financial conditions based on some external information. In other words, for most of the time, stock price reactions lag behind the company's actual revenue changes, and this lagging relationship will be corrected when quarterly financial reports are released. However, in MicroStrategy's business model, since both its holding scale and BTC prices are public information, investors can understand its actual profit levels in real-time, and there is no lag effect because equity per share changes dynamically, equivalent to real-time profit settlement. Therefore, the stock price already reflects all profits accurately, with no lag effect, making it meaningless to focus on its holding costs.
Bringing the topic back, let's look at how the "Davis Double Kill" unfolds. When BTC's growth slows down and enters a fluctuation phase, MicroStrategy's profits will continuously decrease, potentially even to zero. At this point, fixed operating costs and financing costs will further shrink the company's profits, possibly leading to losses. This fluctuation will gradually erode market confidence in the future price development of BTC. This will translate into doubts about MicroStrategy's financing ability, further undermining expectations for its profit growth. Under the resonance of these two factors, MSTR's positive premium will quickly converge. To maintain the validity of its business model, Michael Saylor must uphold the state of positive premium. Therefore, selling BTC to raise funds for stock buybacks is a necessary operation, marking the moment MicroStrategy begins to sell its first BTC.
Some may ask, why not just hold onto BTC and let the stock price naturally decline? My answer is no, more precisely, it is not feasible when BTC prices reverse; it can be tolerated during fluctuations. The reason lies in MicroStrategy's current equity structure and what constitutes the optimal solution for Michael Saylor.
According to the current shareholding ratio of MicroStrategy, there are several top-tier consortiums, such as Jane Street and BlackRock, while founder Michael Saylor holds less than 10%. However, through a dual-class share structure, Michael Saylor has absolute voting power because he holds more Class B common shares, which have a voting power ratio of 10:1 compared to Class A shares. Thus, the company is still under Michael Saylor's strong control, even though his equity stake is not high.
This means that for Michael Saylor, the long-term value of the company far exceeds the value of the BTC he holds, as in the event of bankruptcy liquidation, the BTC he can obtain would be minimal.
So what are the benefits of selling BTC during the fluctuation phase to buy back stock to maintain the premium? The answer is obvious: when the premium converges, if Michael Saylor judges that MSTR's P/E ratio is undervalued due to panic, then selling BTC to raise funds and repurchasing MSTR from the market is a profitable operation. Therefore, at this time, the effect of reducing the circulating supply through buybacks will amplify the equity per share more than the effect of reducing equity per share due to a decrease in BTC reserves. When the panic subsides, the stock price will rebound, and the equity per share will thus become higher, benefiting future development. This effect is easier to understand in extreme cases when BTC trends reverse and MSTR shows a negative premium.
Considering Michael Saylor's current holdings, when fluctuations or downward cycles occur, liquidity is usually tightened. Therefore, when he starts to sell, the price of BTC will accelerate its decline. This accelerated decline will further worsen investors' expectations for MicroStrategy's profit growth, leading to a further drop in the premium rate, which may force him to sell BTC to buy back MSTR, marking the beginning of the "Davis Double Kill."
Of course, another reason that forces him to sell BTC to maintain the stock price is that the investors behind him are a group of well-connected Deep State players who cannot passively watch the stock price go to zero without taking action, inevitably putting pressure on Michael Saylor and forcing him to take responsibility for managing the company's market value. Moreover, recent information indicates that with continuous equity dilution, Michael Saylor's voting power has fallen below 50%, although I have not found specific sources for this information. However, this trend seems inevitable.
Is MicroStrategy's Convertible Bond Really Risk-Free Before Maturity?
After the above discussion, I believe I have fully articulated my logic. I would also like to discuss whether MicroStrategy has no debt risk in the short term. Some predecessors have introduced the nature of MicroStrategy's convertible bonds, and I will not elaborate on that here. Indeed, the duration of its debt is quite long. Before the maturity date, there is indeed no repayment risk. However, my view is that its debt risk may still be reflected in the stock price in advance.
The convertible bonds issued by MicroStrategy are essentially bonds with a free call option. Upon maturity, creditors can request MicroStrategy to redeem them at an agreed conversion rate into stock equivalents. However, there is also protection for MicroStrategy, as it can choose the redemption method actively, using cash, stock, or a combination of both. This provides relative flexibility; if funds are sufficient, more cash can be repaid to avoid equity dilution. If funds are tight, then more stock can be used. Moreover, this convertible bond is unsecured, so the risk from debt repayment is indeed low. Additionally, there is protection for MicroStrategy: if the premium rate exceeds 130%, MicroStrategy can also choose to redeem at cash par value, creating conditions for refinancing negotiations.
Thus, the bondholders will only have capital gains if the stock price is above the conversion price and below 130% of the conversion price; otherwise, they will only receive principal plus low interest. As pointed out by Professor Mindao, the investors in this bond are mainly hedge funds using it for delta hedging to earn volatility returns. Therefore, I have thought through the underlying logic in detail.
The specific operation of delta hedging through convertible bonds mainly involves purchasing MSTR convertible bonds while shorting an equivalent amount of MSTR stock to hedge against the risks brought by stock price fluctuations. As the price develops, hedge funds need to continuously adjust their positions for dynamic hedging. Dynamic hedging typically involves the following two scenarios:
When MSTR's stock price falls, the delta value of the convertible bond decreases because the conversion right becomes less valuable (closer to "out of the money"). At this point, more MSTR stock needs to be shorted to match the new delta value.
When MSTR's stock price rises, the delta value of the convertible bond increases because the conversion right becomes more valuable (closer to "in the money"). At this point, some of the previously shorted MSTR stock needs to be bought back to match the new delta value, thus maintaining the hedging of the portfolio.
Dynamic hedging requires frequent adjustments under the following conditions:
Significant fluctuations in the underlying stock price: For example, large changes in Bitcoin prices lead to sharp fluctuations in MSTR's stock price.
Changes in market conditions: For example, volatility, interest rates, or other external factors affecting the pricing model of convertible bonds.
Typically, hedge funds will trigger operations based on the magnitude of delta changes (e.g., every change of 0.01) to maintain precise hedging of the portfolio.
Let’s illustrate with a specific scenario. Suppose a hedge fund's initial position is as follows:
Buy MSTR convertible bonds worth $10 million (Delta = 0.6).
Short MSTR stock worth $6 million.
When the stock price rises from $100 to $110, the delta value of the convertible bond changes to 0.65, requiring an adjustment of the stock position.
The calculation for the number of shares to cover is (0.65−0.6)×$10 million = 500,000. The specific operation is to buy back $500,000 worth of stock.
When the stock price falls from $100 to $95, the new delta value of the convertible bond changes to 0.55, requiring an adjustment of the stock position.
The calculation for the additional short stock is (0.6−0.55)×$10 million = 500,000. The specific operation is to short $500,000 worth of stock.
This means that when MSTR's price falls, the hedge funds behind its convertible bonds will sell more MSTR stock to dynamically hedge the delta, further driving down MSTR's stock price, which will negatively impact the positive premium and, in turn, affect the entire business model. Therefore, the risk on the bond side will be reflected in advance through the stock price. Of course, in MSTR's upward trend, hedge funds will buy more MSTR, so it is also a double-edged sword.
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