Cryptocurrencies were non existent about a decade ago, and they have certainly come a long way since then. In this article we try to understand how cryptocurrencies are valued, so as to give the investors a better understanding of what they are getting into.

Before we Begin

  • Fundamental analysis forms the backbone of any type of valuation.
  • Performing fundamental analysis for cryptocurrencies is different due to the absence of financial statements to analyze.
  • We have to understand that cryptocurrencies are not companies but currencies, i.e. their viability is not based on generating revenue.
  • It directly depends on the participation of the community, i.e.,
    • Users
    • Miners
    • Developers
  • There is a lack of track record which hampers our ability to assess the viability and potential of the coins.

Factors that Affect Crypto Value

  1. Utility

  • A coin must incentivize people to hold the coins.
  • The more the people that execute transactions, the greater the demand for coins will be and will, therefore, push prices up.
  • Utility also include voting rights, dividend payments or being a medium of exchange.

  1. Scarcity

  • The finite nature of the coins.
  • Demand will push its value up, especially for coins with great utility.

  1. Perceived Value

  • What the markets deem their value to be.
  • Collaborations and partnerships with credible companies enhance the perceived value of a coin.

What is needed for a good understanding of a coin’s fundamentals?

  1. The Right Sources of Information

  • Coin’s White Paper

    • A detailed proposal by the development team which outlines the purpose and mechanics of the coin.
    • Represents the main source for evaluating the fundamentals of the coin.
    • The drawback is that it can get very technical – concepts that are hard for an average person to comprehend.

  • Coin’s Slack Channel or Blog

    • Official channel of communication of the core development team.
    • Joining their slack channel, asking questions to get more information on the coin, viewing the interaction of the development team with the community helps a lot.

  • Community Forums

    • A great way to understand the coins as well as sentiments surrounding the coin.
    • Simple definitions of certain concepts, easy-to-understand analysis of coins from forums can be found as the community is well-informed.
    • It allows one to grasp the mechanics of the coin far better, especially if he/she not technically-inclined.

  1. Cryptocurrency Fundamental Analysis

  • Purpose of Coin?
  • Does it Solve a Real Problem?
  • Does the Coin Possess Any Utility?
  • Is the White Paper a Marketing stunt filled with jargons?
  • Is the Project Funded/Backed by Prominent Investors?
  • Governance Structure-Centralized or Decentralized?
  • Development Roadmap? (clear timeline for the development – indicator of the development team’s commitment)
  • Running “Proof” of the Coin
  • Money Have They Raised? How have they spent it?
  • First mover advantage
  • Difference from the nearest Competitor?
  • The Target Market
  • Significant Legal Barriers?
  • Founding Team Members & Advisors
  • Response through their official channels and forums
  • Supply Structure of the Coin (finite coin supply = stronger value)
  • Market Capitalization of the Coin
  • Allocation of Coins to the Founders (high percentage of Coins to the founders = not a healthy indicator)
  • Is the Distribution of Coins Even? (could result in price manipulation)
  • Cryptocurrencies should be backed by Blockchain technology, not an MLM structure
  • Warnings Relating to the Coin pertaining to scam

There’s no way to determine the inherent value of a cryptocurrency, as there is no asset backing it, but certain calculations can give us a reasonable estimate for the value of cryptocurrencies based on certain assumptions.

  1. Quantity Theory of Money

MV = PT

Where:

  • M is the money supply
  • V is the velocity of money in a given time period
  • P is the price level
  • T is the transaction volume in a given time period
  • the equation as valid over the long-term
  • a large portion of this velocity is just trading volume, not spending volume.
  • criminal activity, since that’s one of Bitcoin’s biggest applications that affects the actual value of goods traded

  1. National Currency Comparisons

  • Cryptocurrency adoption compared to fiat currencies.
  • How much economic activity – the equivalent of GDP, that actually occurs in a cryptocurrency from the active users.
  • Examining active user base of the cryptocurrency, since the ledger is public.

A reasonable forward-looking valuation estimate for a given cryptocurrency:

  • Understand the numbers and growth rates of units existent in a cryptocurrency.
  • Estimate the economic activity to occur in total blockchain cryptocurrencies in long term.
  • How will a given cryptocurrency change its market share.
  • Compare spending patterns to other monetary bases
  • Take into account velocity of money.

Happy investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.