CFDs are a leveraged product and can result in losses that exceed deposits. Please ensure you fully understand how CFDs work and what their risks are, and take care to manage your exposure. CFDs are a leveraged product and can result in losses that exceed deposits. Please ensure you fully understand how CFDs work and what their risks are, and take care to manage your exposure.

How to value cryptocurrencies

In this mini-series, we explore a few possible methods that can help determine the value of a cryptocurrency, such as mining and Metcalfe’s Law. Keep reading to find out what gives a cryptocurrency value and how it impacts trading.

Source: Bloomberg

It can be tricky to work out the value of an asset such as cryptocurrency - especially in an environment that is seen as highly speculative. What we really need is a new valuation process, and one that separates cryptocurrencies from other asset classes.

Why is it difficult to value crypto assets?

In a completely rational market, market price and fair value would be equal – but even in established markets this rarely happens. As a result, figuring out how to value an asset, such as cryptocurrency, can be a difficult process.

Price to earnings (P/E) ratios, market capitalisation, price to cash flow and earnings before interest, taxes, depreciation and amortization (EBITDA) works for stock, while things like rig or drilling counts, supply regulation and macro data releases are useful for commodities. The value is derived from the free and open markets consensus.

Analysts and economists use various methods to try and work out the fair value of an asset. A long price history, combined with agreement on key fundamental factors that influence the asset’s true value, are important parts of the measurement. There is no universally agreed valuation in foreign exchange markets for example, but central banks and investment banks create valuations on each forex pair based on variables that are sensitive to the two economies in question.

How to value cryptocurrencies

Cryptocurrencies, as a new asset class, are currently being shoehorned into the same sort of traditional valuation matrix, as traders and analysts try and get their heads around what constitutes value and, by association, what constitutes a buy or sell signal. What we really need, however, is a whole new valuation process.

When it comes to trading cryptocurrencies, it’s important to have a good understanding of all valuation principles to aid in the trade decision making process. While cryptocurrencies such as bitcoin, litecoin and ether have seen a significant price rise based on speculation, there should be an underlying value, which some people are basing their crypto purchases on.

Three methods for valuing cryptocurrencies:

  1. Cryptocurrency mining

The cost required to create a cryptocurrency is useful for understanding the potential minimum level of that asset. For example, if a cryptocurrency’s mining profitability is high enough, less miners will sell their coins, reducing sell side pressure. But how does this work in the real world? In this article (link above) we look at mining and how it gives cryptos value.

  1. Metcalfe’s Law

Crypto assets such as ethereum are more than just currencies, with some reporters thinking of them more as commodities on a network. Does the network effect - as seen in social media and telephony - have an impact on cryptocurrency asset price? For ether, it seems it may.

  1. Cryptocurrency scarcity

Value comes from utility and scarcity. There are a number of key concepts on how this affects the price action of cryptocurrencies, and some important events, such as the bitcoin halving in 2020, will have a serious impact on supply. In turn, this could affect the price.

This information has been prepared by IG, a trading name of IG Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication.  Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. 

CFDs are a leveraged products. CFD trading may not be suitable for everyone and can result in losses that exceed your initial deposit, so please ensure that you fully understand the risks involved.

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