How To Properly Value A Cryptocurrency
Placing a value on any given cryptocurrency is incredibly challenging. Unlike traditional marketplaces, there are no standardised metrics or models that offer a good indicator of whether a cryptoasset is over or under-valued. The pricing mechanism in crypto has been – for most cryptocurrencies – a total failure, hence we see the absurd levels of volatility that continue even 10 years on from Bitcoin’s first issuance.
Crypto does not have a P/E Ratio. Terms like “market cap” are largely misleading and comparing valuations based on a coin’s US Dollar “price” is of no purpose at all. Ask the average holder of ETH, BTC or DOGE why the price is what it is and they’ll probably run off. We know cryptocurrencies are valuable; they provide utility which no other asset class provides with a scarcity that is bound by the laws of mathematics. Yet no one knows where individual cryptocurrencies lie on the spectrum of “valuable”. Tim Draper predicts Bitcoin to reach $250,000 by 2023 while the Winklevoss twins expect the network value of all cryptocurrencies to exceed $5 trillion within the next 20 years. Skeptics of course, envision certain destruction with the long-term value of all cryptocurrencies trending to zero.
If determining the price is so challenging with hugely split opinions, how can investors make decisions about if and when to buy and how much to risk? This guide will look at some of the more interesting methods for valuing cryptocurrencies, from the basic supply and demand indicators to new metrics such as NVT and MVRV ratios.
Supply & Demand
The supply curve of any decentralized cryptocurrency is distinct from any other asset in the world in that its issuance is fixed by code. Not only is issuance transparent, but the total number of mined coins is transparent too with absolutely no margin for error. Even the most scrupulous of gold bugs would not be able to give you – to the gram – an agreed figure for the total amount of gold mined today. This unprecedented level of transparency and auditability in crypto gives its holders an unrivalled confidence in the value that they own. Yet while these basic principles hold true across all decentralized cryptocurrencies, the supply schedules in which they operate can differ vastly:
Bitcoin’s consensus rules will only ever allow 21 million coins to be mined, at which point, the currency’s supply will become deflationary as coins are lost or burned.
Ethereum’s consensus rules state that 2 ETH will be minted when each block is mined (roughly every 15 seconds) with no limit on the amount issued.
XRP launched with 100bn tokens, 40bn of which are circulating today with the remainder locked in escrow on the XRP ledger.
GRIN has a fixed rate of issuance at 60 coins a minute for perpetuity.
Ethereum vs Bitcoin inflation rate (%) – CoinMetrics.io
A coin’s price is highly correlated to its scarcity (supply), a cryptocurrency that inflates forever would not be as attractive as one that does not. Yet a cryptocurrency with a fixed supply also raises questions: in the case of Bitcoin, once 21 million coins have been mined, miners – who secure the network – will be rewarded in transaction fees alone which could drive away the blockchain’s critically important hash power. Such a security model has never been tested before and an eternally fixed supply schedule may be as toxic as its opposite.
How a cryptocurrency’s supply changes over time is a key factor in determining a coin’s value. Not only this, but trust in the currency’s future supply is also critical. For all of the potential flaws of a fixed total supply, the absolute certainty over Bitcoin’s future issuance is extremely compelling when considering its utility as a store of value. In the same light, a major criticism of Ethereum is that its future supply schedule is relatively unknown. While issuance has fallen since the coin was launched, it has done so at a non-linear rate and often quite sporadically. We know that Ethereum’s inflation rate will trend towards zero over time, but it is not guaranteed and the timeframe is uncertain.
For measuring demand the best indicators can be found on the blockchains themselves. Metrics like active addresses and transaction fees all provide an indicator of how much the blockchain is being used and thus demand. However, these metrics fall down when considering a store of value blockchain like Bitcoin whose value increasingly derives from “hodling” as opposed to using. In the case of Ethereum, whose platform is general purpose, transaction fees are a good indicator of whether said purpose is being served. Plenty of investors approach Ethereum in the same hodling mindset of Bitcoin, however its future value could derive from a plethora of use-cases, many of which are yet to be imagined. For those looking to compare onchain data, I highly recommend checking out the CoinMetrics charts.
Fund managers, analysts and data aggregators are doing their level best to come up with new metrics that can be used to measure the value of this emerging market. The following have so far gained the most traction among peers.
“Network Value To Transactions Ratio” aims to serve as a similar indicator to the Price Earnings Ratio of traditional equities. To calculate the NVT of a blockchain, simply divide the market cap by the 24 hour USD volume transmitted on the ledger. Such a ratio can be used to compare one blockchain with another, or with the same blockchain’s historical NVT. A high NVT suggests that the market cap of the blockchain is outpacing its usage and as such, the blockchain may be overvalued. Conversely, a low NVT would indicate that the blockchain is undervalued.
Ethereum vs Bitcoin NVT – CoinMetrics.io
Introduced by Nic Carter from Castle Island Ventures, Realized Cap is a new take on the Market Capitalization metric derived from multiplying coin supply by current coin price. Instead of using the current price of a coin, Realized Cap uses the price of the coin at the time when it was last moved. Realized Value takes into account the high volume of hodlers in this space; those who buy a cryptoasset, leaving it dormant for months or years in the hope that it appreciates in value.
Market Value (market cap) To Realized Value is a ratio which simply divides MV by RV. MVRV has been used to help determine whether an asset is over or undervalued. This chart from Nic Carter during his talk at Baltic Honeybadger 2018 displays this neatly.
The chart shows the market value and realized value of Bitcoin Cash overtime. It can be seen here that during the bull run of 2017, the MVRV ratio rapidly increased as market value was outstripping realized value. The primary reason for this was that a large portion of the forked BCH coins were not moved or sold. This resulted in a huge number of inactive coins being used in the calculation of the cryptocurrency’s market value and arguably giving a false indicator of the network’s real value. Such a high MVRV could indicate that the cryptocurrency is over-valued, which was especially true in the case of Bitcoin Cash. Eventually, the market value of BCH trended towards a very flat realised value curve.
Determining the exact US Dollar value of a cryptocurrency is extremely difficult, however determining relative values within the cryptocurrency market itself have proven a lot easier. As an example of how one may apply a relative valuation between coins, we’ll look at the highly liquid ETH/BTC currency pair.
Using supply figures from the year 2050 as means for comparison, Bitcoin will have an issued supply of nearly 21 million with Ethereum at around 120 million. Assuming equal utility of ETH and BTC as well as all other things being equal, the price of ETH/BTC would be 0.175 BTC (21M / 120M). Of course, we know that ETH and BTC do not have equal utility now or in the future. Given Bitcoin’s potential as a replacement of digital gold and Ethereum’s potential as the underlying asset of a new financial system, 0.175 BTC would seem like a lower-bound when considering a long-term time horizon. Yet in December 2018, ETH/BTC traded as low as 0.02465 BTC, a price which is hard to imagine will ever be seen again based on the simple fundamentals outlined above. There are certain periods in the boom and bust cycles when a cryptocurrency’s pricing is extremely out of kilter. Investing at such a point can be done with some confidence as even a significant misjudgement can still prove profitable if the assumptions were correct and the market’s price was indeed very far reality.
To invest using relative values, it’s essential that the trader has a good knowledge of both sides of the market and their short, medium and long term road maps.
Valuation Metrics To Be Wary Of…
There are numerous metrics which can be spun into a “measure of value” that are in fact simply misleading. The incentive for ICOs to deceive investors is significant and there are all manner of metrics which do not give any real insight into potential value.
- Market Cap
- Social Metrics
- Developer Metrics
- Blockchain Metrics
While useful for establishing values of highly liquid cryptocurrencies, using market cap to evaluate illiquid cryptocurrencies can be wildly misleading. For example, a new cryptocurrency could simply game the system by issuing 100 billion tokens making a $1 trade at an unknown exchange, providing a market cap “valuation” of $1bn. It is therefore possible for a currency to be considered a top 100 coin when in reality it has no value at all.
These metrics, such as Reddit subscribers and Tweets, can be easily gamed. In fact, these metrics are so commonly used as part of the valuation process that it is not uncommon to find ICO tokens with paid followers. Not only that, but the following of a single handle may not give the whole picture as the blockchain may have multiple accounts operating at different layers (consider Bitcoin Core and Lightning Labs for example).
In a similar light to social metrics, the number of commits or lines written in a GitHub repository can be wildly misleading. Not all commits are equal, and again, can be easily gamed. It’s also worth noting that for blockchains like Ethereum, the core client only accounts for a small proportion of the development taking place. Arguably more interesting and higher value activity is taking place on second layer solutions and – to the contrary – a slowdown in core activity is often desirable.
Transaction counts and active addresses are all potential sources of deception, particularly in blockchains with no fees and the potential for spam transactions to feign activity.
Hopefully this article has inspired some interesting routes for your own price discovery. If you had any fundamental pricing methods that you feel are worth adding, leave a comment below!