A Beginner’s Guide on How to Value Crypto Assets
Finding the value of cryptocurrencies can be quite daunting, especially for beginners. Nonetheless, it’s crucial to value crypto assets to calculate their fair market value and predict future or possible market prices. Unlike bonds, stocks, and real estate, where the value of investments is evaluated based on the company’s financial statements, historical price charts, etc.
Crypto assets are evaluated using varied methods. Common ways of valuing financial assets in traditional markets include the P/E method or Price/Earnings ratio, discounted cash flow, and the Gordon growth model. While it’s challenging to value crypto assets, it’s still possible to obtain their real value and make profitable investment decisions. Here’s an in-depth look at how you can value crypto assets using the available methods.
History of Valuing Crypto Assets
Crypto assets valuation started with ARK Investment Management– a global asset manager specializing in thematic investment strategies spanning market capitalizations, sectors, and geographies. The company was the first public company to invest in Bitcoin in 2015. At the time, no investment company thought cryptocurrencies were a lucrative investment. Lead by Chris Burniske, co-author of “Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond,” ARK valued Bitcoin at earlier stages and established the potential for significant growth.
What are the Challenges of Valuing Cryptocurrencies?
Valuing crypto assets is challenging. For a start, valuation approaches in the traditional financial markets cannot be applied in valuing crypto assets. Besides, there is a lack of a precise conventional method for valuing crypto assets. Some of the challenges of valuing crypto assets include:
- Cryptocurrencies and blockchain networks that they are built on are not companies. Crypto assets are a medium of exchange independent of any bank or central authority. Therefore, they don’t have cash flows, plus their value doesn’t depend on its capacity to generate revenue; instead, there is popularity and trading volume. Without any apparent cash inflows, it becomes complicated to establish the precise value of crypto assets.
- Lack of financial records makes it hard to establish the precise value of crypto assets. Most cryptocurrencies have been in existence for less than five years and are still developing. Crypto assets are decentralized; thus, financial records are not kept by any central authority. This makes valuation challenging.
Valuing Cryptocurrencies: What to Consider
Despite the challenges, it’s still possible to value crypto assets by estimating their value based on the interaction of various factors affecting them. Some factors to consider when valuing crypto assets are:
The value of crypto assets is mostly affected by its utility. The higher the utility, the higher the crypto asset attracts much value. For instance, Ether has a high-value thanks to its utility on the Ethereum blockchain used to develop smart contracts. ETH is needed for anyone of the Ethereum blockchain to execute commands and develop applications.
The perceived value of crypto assets also drives the relative value of cryptocurrency. The perceived value of cryptocurrencies is affected by numerous factors, including energy usage, usability, and investors’ interest.
Demand and Supply
Demand and supply directly affect the value of crypto assets. Crypto assets with limited supply and high demand, such as Bitcoin, have a higher value than coins with high supplies and low demand. Bitcoin’s total supply is capped at 21 million to keep its value high.
Approaches to Valuing Crypto Assets
Crypto assets can be valued using both qualitative and quantitative analysis.
There are several quantitative analysis approaches in valuing crypto assets as below.
- Equation of Exchange Formula
ARK Investments came up with a unique economic model to assess the value of crypto assets. They established a formula called the Equation of Exchange. The formula is as below:
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
- Sharp ratio
A sharp ratio involves valuing an asset’s value by analyzing its historical price data. The sharp ratio is calculated by dividing the asset’s return on investment by the asset’s volatility. Crypto assets with a sharp ratio above 1.0 are considered valuable.
- Factor Analysis
Factor analysis is a valuation method in the traditional stock market that can still value crypto assets. In factor analysis, crypto assets are grouped in a portfolio using several factors, usually three to six.
Bloomberg carried out a Factor Analysis valuation on crypto assets, grouped them into three portfolios: Size, Quality, and Service. The Size portfolio included Bitcoin, Ethereum, XRP, Litecoin, NEM, and Ethereum Classic. The Quality portfolio included Bitcoin and Ethereum, while the Service portfolio included currencies that offer services, notably STEEM and Iconomi.
The analysis ranked the Size portfolio to have the highest value, while the Quality portfolio had the most volatility. Bloomberg’s crypto-asset valuation approach has some level of accuracy since it reflected the performance of crypto assets.
Qualitative analysis, unlike quantitative analysis, looks at the traits of a particular crypto asset. The analysis involves looking at:
- The community behind a project
- The core team behind the project and their qualifications in achieving the goals of the project.
- Analyzing the project’s white paper and determining whether solving a particular issue will be meaningful or not.
- Establishing the views of experts towards a particular crypto project.
Like other financial instruments such as stocks and bonds, cryptocurrencies attract value. However, valuing crypto assets is challenging, considering that they lack flows, inventory, and other traditional economy elements. Therefore, it’s impossible to value crypto assets using conventional financial valuation methods such as Discounted Cash Flow, P/E evaluation, and the Gordon Growth Model. Additionally, the lack of a conventional and precise crypto valuation method makes it challenging to value crypto assets.
Nonetheless, it’s still possible to value crypto assets using qualitative and quantitative approaches. Quantitative approaches involve looking at the sharp ratio, using the Equation of Exchange formula, performing Factor Analysis, and looking at the Network value to transaction ratio. Qualitative approaches involve analyzing the core team behind the project, the whitepaper, and looking at how other blockchain experts think about the project. In essence, while it’s difficult to value crypto assets, it’s crucial to establish their exact value to determine if they’re a lucrative investment.