How to value a cryptocurrency
Fiat currency prices are usually determined in two ways: a floating rate or a fixed rate. A floating rate, when the currency changes continually based on a multitude of factors, is determined by the open market through supply and demand on global currency markets. If the demand for the currency is high, the value will increase. And vice versa, if the demand is low, the value will decrease.
In traditional stocks, the “fair” price/intrinsic value can be estimated with different kinds of valuation methods and models, discounted cash flows, dividend discount models, price to cash/free cash flow/book ratios, earnings per share, to name a few. Even though the usage of these methods in the traditional markets is not always perfect, it is something tangible that investors can rely on.
Currencies however, can not be valuated with this framework. As mentioned before the value of a currency is derived from its usage. Supply and demand are the biggest factors that affect the exchange rate of a currency. Other aspects like inflation rate, interest rate changes, GDP numbers, manufacturing data, and unemployment rates are also material for the valuation of a currency. The bigger currency markets are generally less volatile due to the fact that these variables are published frequently and a healthy supply and demand ratio.
With cryptocurrencies it is even more difficult to derive at a fair value. There are multiple kinds of cryptocurrencies, the actual currency kind without utility, the ones that do have utility besides the function of a currency. And there are also cryptocurrencies that do not have either, it is not used in real life to buy goods or services and it does not have utility because the platform of the currency is not operational.
Without utility or purchasing power, there is no real way to assign a fundamental value to an asset. The price of most cryptocurrencies at the moment comes from speculation, namely a promise of future purchasing power. Everyone has a different opinion of what the fair price is and because there is no valid way to valuate a crypto coin the prices fluctuate enormously. Which obviously makes investing in cryptocurrencies inherently riskier than traditional financial assets.
One way of tackling this problem is by looking at the inflation rate of currencies. Despite inflation being one factor of many that affect the exchange rate of currencies, it is the one that is most likely significantly negatively affect the exchange rate than significantly positively affect the exchange rate
Often, a high inflation rate exhibits devaluing of a currency due to a faster-growing supply than demand. This phenomenon can be especially observed during recessions when decision makers inflate the money supply with quantitative easing in order to stimulate the economy.
With cryptocurrencies inflation rate is stable and predictable. A lot of cryptocurrencies have a finite supply of coins it can mine or mint. The total number of Bitcoin that can exist is 21,000,000. Bitcoin’s block rewards halve every 210,000 blocks (or around 4 years). Because the supply is shrinking with time, instead of increasing (like fiat currencies), it can create a sense of scarcity.
If we look at Bitcoin as a commodity there is another way of valuating it by using the stock-to-flow model. Based on the model, a commodity is considered to be scarce if its newly issued supply per year is few percent of their already available total supply.
By looking at the scarcity and the total market value of a commodity, we can estimate its value compared to other commodities. The Twitter user @ PlanB has conducted a research which applies the stock-to-flow model to several well-known commodities.
He plotted gold, silver, platinum, diamond, palladium, and Bitcoin on a chart using the market value and scarcity of each commodity. The outcome suggests that the more scarce a commodity is, the more valuable it is and all the commodities lie closely to a straight line but Bitcoin. Based on the assumption that Bitcoin is comparable to those physical commodities, the market value of Bitcoin should be much higher. However, there is no logical reason to be certain that every asset should fall close to the exhibitted line or Bitcoin would be part of the group of physical commodities. It is possible that Bitcoin has the ‘correct’ value and is just deviating from the “estimation”.
Investing in cryptocurrencies?
Icoinic is the first Digital Asset Fund of the Netherlands located at the oldest stock exchange in the world; the Amsterdam stock exchange. Icoinic manages to combine experienced traditional traders with young crypto specialists and developers with knowledge in all topics relating to investment in and trading of crypto assets. This unique composition of experts from various fields, in combination with the location right at the center of the financial heart in The Netherlands provides Icoinic with a competitive advantage in this young but vibrant market.
Find out more about Icoinic and our fund at our website.