What is Your Crypto Really Worth? – How To Valuate Crypto Assets
Valuation, an established process used by financial analysts, gets to the bottom of this question. Here we will touch base on basic token economics and work our way to crypto assets valuation methods.
How much is your crypto really worth? Valuation, an established process used by financial analysts, gets to the bottom of this question. Here we will touch base on basic token economics and work our way to crypto assets valuation methods. Read on to deepen your understanding of cryptocurrencies and to DYOR – do your own research, the motto of the crypto world.
What is Asset Valuation?
Valuation is the analytical process by which the current or projected worth of an asset is determined. There are a lot of different valuation methods, however, each method may yield a different result and one method may be more suitable than another depending on the asset class and company.1
Traditionally, financial analysts rely on a company’s financial statements to perform quantitative analysis. However, crypto-assets do not provide this type of information, therefore traditional methods are mostly inapplicable.
It is then imperative for the industry to continue to explore and develop new valuation methods as they draw in institutional investors.
Price, Supply, and Market Capitalisation
The basic equation for measuring how much cryptocurrencies are worth is by looking at their market capitalisation, calculated by this equation:
Where:
MC = Market capitalisation
P = Token’s unit price
S = Token supply
Here is the snapshot for the market on the 4th November, 2019:
Supply
For stock, the number of shares issued to the public (or kept by the company) is determined by the company during an IPO. Similarly, for cryptocurrency, the amount of tokens issued to the public (or kept by the company/foundation) is determined by the company/foundation during ICO.
Some coins may have an inflationary supply due to new coins being issued through mining. Some coins may have a deflationary supply due to tokens destroyed via coin burning. Hence there are many devils in the details for various kinds of token supply.
Supply is controlled by the company/foundation or the token’s pre-defined algorithm. In general, it is not a variable that can be controlled by the market.
Price
Price is the agreed transaction price from buyers and sellers in the market. It is the most intuitive value used for calculating profit and loss, rate of return and performance of the asset. It is a variable that will fluctuate every day due to market activities.
However, some tokens pegged to fiat (or other assets) may have a price that is not controlled by market activities in the crypto ecosystem. Examples include Tether (USDT) where the price is always equal to 1 USD, or Pax Gold (PAXG) which is linked to the price of gold.
Market capitalisation
Market capitalization is simply calculated by multiplying the price of a crypto asset by its supply. It is useful to compare, rank, and analyze different tokens. It also represents the token value locked (in USD) for the particular token. We may also use market capitalization to compare the size of the cryptocurrency market to other markets (such as stock or commodities) in the form of total capitalization.
Token Supply and Inflation
Token supply
Token supply provides crucial information on how many tokens were or will be created, and how many of them are circulating in the secondary market. However, the term ‘token supply’ comes in different expressions when we try to look into the token supply of different cryptocurrencies:
- Circulating (current) token supply: The number of tokens in circulation at the time ‘t’, for some ICO projects, the team may have a significant number of tokens locked in their wallets, and this is not considered in the circulating token supply as they are not available in circulation.
- Maximum (total) token supply: This is a fixed number, which refers to the total number of tokens that have been (or will be) created. This number is decided before the first coin is ever created. For bitcoin, this number is 21,000,000.
- Unlimited supply: This is for a token that bears an inflationary model and does not have a fixed total supply. For example, Ethereum and EOS.
There are debates about whether we should use circulating supply or total token supply when calculating market capitalization. One good example is XRP, where the company (Ripple Labs) is holding > 60% of tokens. Based on the number on the 4th of November 2019:
From the example above we can see that the supply that we are using may have a significant impact on the valuation of the token.
In general, we should pick circulating supply as the base for calculation. For tokens that are not in circulation (either they are not yet mined, or are still being locked), they are equivalent to not yet existing and have no impact on the market’s demand and supply curve, hence should not be included when we calculate the market capitalization.
Inflation
Token supply is not a constant number, the number may keep changing continuously. The current circulating supply may increase through mining, staking, or releasing of the founders’ (or investors’) tokens. This creates inflation in the token.
Inflation is not something new and exists for fiat currency as well. All central banks use money supply (and inflation) as a tool to manage the economy. The most famous example is Quantitative Easing during the 2009 subprime crisis.
Here are some examples for the inflation rate of selected cryptocurrencies:
Different cryptocurrency projects have different inflationary models, for example, bitcoin’s inflation rate drops sharply every 4 years due to halving. Meanwhile, Stellar has a stable 1% inflation rate. Some may even be deflationary like the Binance coin which has reduced supply due to coin burns every quarter.
Assuming a constant market capitalization, the higher the inflation rate, the worse the price performance. Hence, the inflation rate is an important factor when we consider the potential performance of a cryptocurrency.
Coin Burns, Lock-ups, and Buy Backs
We have now introduced the term ‘coin burn’, but how it is linked to deflationary token supply?
Coin burns
Coin burn is the process in which a certain amount of coins is sent to an address without a known private key, essentially resulting in a permanent reduction in supply for the token.
A notable example would be Binance Coin (BNB), Binance will burn BNB every quarter equivalent to 20% of their net profits. It provides fuel for the price of BNB to go up and gives investors confidence, as they believe the token supply is gradually decreasing and there are profits of the company backing the price of the token.
Lock-ups
Lock-up is another way to (temporarily) reduce token supply. The action may be executed through smart contracts or a centralized exchange. The locked tokens cannot be sold or transferred for a certain period. In return, they are compensated with various benefits, like access to the CRO Crypto.com Visa Card, or lock-up rewards for selected cryptocurrencies such as BTC, ETH, LTC, and CRO.
Unlike coin burning which will reduce circulating supply permanently, lock-up will only have a temporary effect causing some tokens to not be tradable in the market for a certain period. Hence, it is actually reducing the token velocity instead of the token supply. Besides, lock-up will not change the amount of circulating supply being displayed.
Buybacks
Sometimes a company/foundation may need to buy back its tokens from the public as they no longer have enough reserve for the tokens.
Buyback is essentially similar to the notion of share buybacks by publicly owned corporations, which reduce the amount of stock available. As the supply of coins decreases, the price may go up assuming other things are constant.
Supply and Price
All examples above are events that will reduce token supply. The relationship between supply and price can be easily illustrated by the basic economics supply and demand curve:
As the token supply decreased from S to S1, the demand may drop but the price will increase from P to P1. This applies to all coin burn, lock-up, and buy back events. However, readers should note that reduced supply may go back into circulation for lock-up (through unlock) and buy back (through company selling).
Putting it All Together: Financial Valuation
And there you have it. Now you got the base parts that are used to evaluate what a cryptocurrency is really worth. In the next step, we look at classic financial valuation models and then at how these were adapted to fit the DeFi world of cryptocurrencies.
References
1. Chen, James. “How the Valuation Process Works.” Investopedia, Investopedia, 18 Nov. 2019, https://www.investopedia.com/terms/v/valuation.asp.
2. Chen, J. (2019, October 3). Time Value of Money (TVM) Definition. Retrieved from https://www.investopedia.com/terms/t/timevalueofmoney.asp.
3. Chen, J. (2019, July 15). Understanding Discounted Cash Flow (DCF). Retrieved from https://www.investopedia.com/terms/d/dcf.asp.
4. Chappelow, J. (2019, October 16). Equation of Exchange Definition. Retrieved from https://www.investopedia.com/terms/e/equation_of_exchange.asp.
5. Burniske, C. (2017, September 24). Cryptoasset Valuations. Retrieved from https://medium.com/@cburniske/cryptoasset-valuations-ac83479ffca7.
6. Ciaian, P., Rajcaniova, M., & Kancs, D. A. (2015). The economics of BitCoin price formation. Applied Economics, 48(19), 1799–1815. doi: 10.1080/00036846.2015.1109038
7. Mitchnick, R., & Athey, S. (2018, June). A Fundamental Valuation Framework for crypto assets. Retrieved from https://s3-us-west-1.amazonaws.com/fundamental-valuation-framework-for-cryptoassets/A Fundamental Valuation Framework for Cryptoassets_June 2018.pdf.
8. Chen, J. (2019, March 12). Relative Value. Retrieved from https://www.investopedia.com/terms/r/relative-value.asp.
9. Woo, W. (2017, February 24). Bitcoin Value to Volume Ratio. Retrieved from https://twitter.com/woonomic/status/835015883051298816?ref_src=twsrc^tfw|twcamp^tweetembed|twterm^835015883051298816&ref_url=https://cryptoticker.io/en/bitcoin-nvt-ratio/.
10. Woo, W. (2017, October 2). Is Bitcoin In A Bubble? Check The NVT Ratio. Retrieved from https://www.forbes.com/sites/wwoo/2017/09/29/is-bitcoin-in-a-bubble-check-the-nvt-ratio/#7dfdb2436a23.
11. Burniske, C. (2017, September 5). The Crypto J-Curve. Retrieved from https://medium.com/@cburniske/the-crypto-j-curve-be5fdddafa26.
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