November 20, 2018

How to Value Cryptocurrencies

Cryptocurrencies are truly a unique type of investment. On any given day, a crypto may see double or even triple-digit gains or losses, making it incredibly difficult for most traders to determine the actual cryptocurrency value of a particular coin.

However, if you invest in Bitcoin or any other digital currencies, knowing how to compare a currency’s current trading value and its actual (intrinsic) value is important, as it helps you to decide when to buy (if the market is undervalued) or to sell (if the market is overvalued).

Although, the traditional valuation models that are used to determine the values of bonds, stocks, fiat currencies or commodities do not translate very well to cryptocurrencies. This is because they do not have any dividend payments, recurring cashflows or a specific terminal value which can be estimated.

Still, there are models that can help you to determine what the real value of a cryptocurrency is, through absolute valuation and relative valuation. Note that the valuation models should not be used as the basis for investment in cryptocurrencies on their own, but they can help you to understand the forces that drive a digital currency’s value.

Absolute Valuation Model – Equation of Exchange Monetary Model

Also known as the Quantity Theory of Money, it is a useful tool to use when valuing cryptocurrencies. The reason for this is that this model seeks to establish the value that is provisioned to users within a cryptocurrency network, relating this value to the supply and velocity of coins to derive what an individual coin is worth.

It is a macroeconomic model that can be used to relate the supply of money, its velocity, and the price level, as well as an index of expenditures. The equation of change is:

MV = PQ

Where:

• M = The average nominal supply of money circulating within an economy. In this case, it represents the total number of coins of a particular cryptocurrency.
• V = This is the velocity of money, which is a measure of the frequency with which a coin of cryptocurrency is spent.
• P = A cryptocurrency’s price level.
• Q = The index of real expenditures.

Use Cases for the Equation of Exchange Model

In the most general sense, using the Equation of Exchange to value a cryptocurrency is necessary in several use cases including:

• Projecting the supply schedule for units of a currency. This lets you know when coins will be available and how many will be traded.
• Providing an estimate of the share of the market that the cryptocurrency is expected to reach and offering an S-adoption curve.
• Attempting a forecast of the cryptocurrency velocity.
• Establishing the discount factor that is required to bring a currency’s future utility into the present.

Limitations of the Quantity Theory of Money

Like any other economic model, the use of this model to value cryptocurrencies has its limitations. These limitations are:

• There is not much data available with regard to the velocity of cryptocurrencies, and the little information available varies from one cryptocurrency to the next.
• On-chain crypto transactions are used to substitute for GDP in fiat currencies. However, a significant number of these transactions are simply coins moving from one exchange to the next.
• It is not easy to accurately ascertain the percentage of tokens that are actually traded, which should be factored into the float.
• Other related details are also difficult to determine. For instance, it is not easy to determine the extent to which velocity correlates to other variables, or cases where it should be treated independently, or how to account for the value of forks in the chain.

Relative Valuation Models for Cryptocurrencies

There is also potential in the use of relative valuation models for cryptocurrencies. However, this is an area where there is little compelling work available at the moment. Still, there are some interesting metrics that can be used to make comparisons and therefore help to arrive at relative valuations. These include:

• Value-to-transactions ratio: A Network Value to Transactions (NVT) ratio is a measure of the dollar value of the market cap of a cryptocurrency in relation to its daily transaction volume.
• Transactions per second: This is a useful metric for cryptocurrencies seeking mass adoption by consumers.
• Characteristics of the currency ownership base: A part of the value of a particular cryptocurrency may depend on factors, such as the number of users who own more than a particular number of coins, the concentration of ownership and the percentage of supplied coins compared to user holdings.
• Mining profitability: The nature of a cryptocurrency’s mining and how profitable miners find it to be is a useful metric when examining ownership structure.
• Distribution and trading volumes: This examines the exchanges on which a cryptocurrency is available and how transaction volumes are distributed across these exchanges.

The Final Word

It is clear that much still needs to be done to develop models that can accurately value cryptocurrencies. The future value of any digital coin is bound to be connected to staking, incentive and distribution models within a given project. With this in mind, it is likely that models will be developed in the future to examine each coin independently, rather than a one-size-fits-all model.