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.

Bitcoin
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.

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