Brought to you by the Liquid team to help you make sense of crypto.
Now you want to invest. But with thousands of cryptocurrencies to choose from, how can you determine the value of crypto assets?
We'll run you through the basics in this post.
Before we get into the specifics of how to value cryptocurrencies, let’s first address the purpose and context of valuing assets.
Valuing is what stock market investors do to calculate the fair market value of a stock. In reality, the values are theoretical. They are used to predict future or potential market prices.
And, of course, the purpose of valuing is to provide investors with the information to make investment decisions that meet their goals.
Forms of valuing in traditional markets
There are several common strategies for valuing assets in traditional markets:
- The P/E method or Price/Earnings ratio is generally the best known of the investment valuations. It follows a simple approach, where a company’s stock price per share is divided by a stock’s earnings per share to find a present value for a stock to determine its future value.
- Discounted Cash Flow uses a company’s future cash flow projects and discounts them, with an annual rate, to determine a present value estimate. That present value estimate is then used to evaluate the potential for investment.
- The Gordon Growth Model uses an approach that takes a dividend per share that is payable in one year, with the assumption that the dividend grows at a constant rate in perpetuity.
Challenges of valuing cryptocurrencies
The above examples are approaches to valuing currencies for the traditional stock market—for stocks that represent companies with cash flow, inventory and other elements of the traditional economy.
However, applying these valuation approaches to cryptocurrencies has a few challenges.
First, and most importantly, cryptocurrencies and the blockchain networks that generate them are not companies. They don’t have cash flows.
This presents a few key problems. Notably, because of this, it's impossible to apply the Discounted Cash Flow approach. The same goes for P/E evaluation, because cryptocurrencies are not stocks that can be evaluated by price per share.
Some people argue that cryptocurrencies shouldn’t be called currencies at all because they do more than exchange value. They’re also not commodities, because they aren’t consumable.
An additional difference is that the crypto market is very young, so there is little data of currencies’ past performance to use when assessing how these assets might perform in the future.
Key aspects of valuing cryptocurrencies
To develop a full concept for how to value cryptocurrencies, it’s important to keep in mind three specific topics: Utility, Scarcity and Perceived Value.
Utility is, obviously, how a coin can be or is used, and its use in the specific blockchain network to which it is related.
Ether, for example, is the currency of the Ethereum blockchain, which has gained success because of the growing value of Ethereum’s smart contract technologies. ETH is required for anyone on the blockchain to execute commands and develop applications, so ETH is a currency within this system.
As Ethereum technologies are leveraged more often and people execute more transactions with ETH, its value increases.
Scarcity is another unique aspect of cryptocurrency. In traditional economies, scarcity and rarity drive the value of an item. Think of diamonds. Or luxury cars. One of the things that gives them value is the lack of them in the marketplace. The same can be applied to cryptocurrencies as they are in limited supply.
Perceived value also drives the relative value of a cryptocurrency. In the crypto marketplace, perceived value can be achieved by various means.
Within the community, value can increase if a project continually meets its stated goals. Or value can increase if people outside of the crypto market see value in a blockchain network. Again, Ethereum is a good example.
And, of course, there's Bitcoin, in many ways the primary cryptocurrency, often generating massive interest among the general population.
Background of valuing cryptocurrencies
One of the first companies to value cryptocurrencies was ARK Investment Management. ARK was the first public fund manager to invest in a security that offered exposure to Bitcoin.
One of the people leading that decision was Chris Burniske, co-author of "Cryptoassets: The Innovative Investor's Guide To Bitcoin And Beyond."
When ARK invested in Bitcoin in 2015, basically no other investment firm thought cryptocurrencies were a good investment. But Burniske and others at ARK, after valuation, recognized that there was potentially significant growth in cryptocurrency.
Approaches to cryptocurrency valuations
What ARK Investments—and ensuing firms and individuals—identified is that cryptocurrencies represent and comprised a wholly unique economic model that required its own form of analysis.
To assess the value of the assets, they developed an approach called the Equation of Exchange. The formula looks like this:
MV = PQ
- M = Size of the asset base
- V = Velocity of the asset
- P = Price of the digital resource being provisioned
- Q = Quantity of the digital resource being provisioned
Another way to value cryptocurrencies is to apply the method of Factor Analysis. In the traditional stock market, this valuation breaks down assets into several factors, usually three to six, and groups those stocks into a portfolio.
Bloomberg did a Factor Analysis study where it grouped crypto assets into three factors: Size, Quality and Service.
The Quality portfolio included Bitcoin and Ethereum.
And the Service portfolio included currencies that provide services, such as STEEM (the currency for the blockchain social media platform Steemit which has a social media functionality) and Iconomi (which enables people to manage digital assets).
Overall, Bloomberg’s analysis found that the Size portfolio tripled, the Service portfolio was the only one to crash, and the Quality portfolio had the most volatility.
The one challenge with applying this approach is, once again, that because cryptocurrencies are new currencies the amount of data that can be used to group coins into factors is limited.
However, Bloomberg’s approach did yield data that showed a relatively accurate snapshot of the performance of crypto assets.
Again, valuing crypto assets is still a difficult task, but some of the above approaches can begin to serve as ways that both investment funds and individual investors can value these assets to determine if they’re the right investment for their financial goals.
This content is not financial advice and should not form the basis of any financial investment decisions nor be seen as a recommendation to buy or sell any good or product. Trading cryptocurrency is complex and comes with a high risk of losing money, particularly if you trade on leverage. You should carefully consider whether trading cryptocurrencies is right for you and take the time to learn how trading works and decide how much money you are prepared to lose.
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