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Valuing Cryptocurrencies

Valuing Cryptocurrencies

Cryptocurrencies exist only digitally, but that doesn’t mean they don’t have real value. But what is value and how can we define it for cryptocurrencies?

Let’s move on to our next lesson. Today we are covering how to value cryptocurrencies. Here’s what you will learn:

  • The meaning of intrinsic value and market capitalization.
  • The six different reasons regular money has intrinsic value.
  • The seven various factors impacting a cryptocurrency’s intrinsic value.
  • Two good rules of thumb to value any cryptocurrency.
  • Why just looking at a coin’s price isn’t a good way of valuing it.
  • Why intrinsic value and market capitalization influence the value of a cryptocurrency.

You’ve read the terms intrinsic value and market capitalization (or market cap) a lot so far. That’s why we’ll first define those two key terms of the day.

What is intrinsic value?

Intrinsic value is the value of a commodity in itself. Take chocolate as an example. Chocolate is valuable first and foremost because of its delicious sweet taste, so this would be its intrinsic value. Fiat money, i.e., the money we use every day, also has intrinsic value. It comes from six different factors:

intrinsic value of money

Scarcity

Although it sometimes might seem this way, we have learned in lesson 5 (LINK HERE?) that there isn’t an unlimited amount of money around. The less money there is, the more valuable it becomes.

Divisibility

Have you ever tried paying for chewing gum with a hundred-dollar bill? It’s possible, but it’s simpler to pay with a few $1 bills. Being easily divisible means, we can value and transact different goods in a much more convenient way.

Utility

It would be kind of hard to pay for your restaurant bill by trading in a computer game or mowing the owner’s lawn. That’s why money is useful. It enables us to value different goods and services.

Transportability

Money is much easier to carry around than precious metals like gold or other valuable items, especially the more you have of it.

Durability

You can burn or tear a bill apart, but overall, bills and coins are pretty durable and don’t break easily.

Counterfeit Risk

Nowadays, you don’t even think about whether the money in your wallet is real or not. It has become so difficult to fake money that we simply assume we have an actual bill in our hands.

All of these factors make up fiat money’s intrinsic value, even though, in reality, it is just colored pieces of paper with numbers on it. Cryptocurrencies also possess all of these attributes. We will look into how they affect its value a bit later. First, we have to clarify our second key term: market cap.

What is market capitalization (market cap)?

Market cap is the circulating supply of a coin, meaning the coins that are currently freely available multiplied by the price of one coin. Say there are 18 million bitcoin available and each bitcoin costs $30,000. Hence:

SUPPLY x PRICE = MARKET CAP
18,000,000 x $ 30,000 = $540,000,000,000

The market cap of Bitcoin is $540 billion. The more bitcoin there are on the market (a maximum of 21m) or the higher the price of each coin, the higher the market cap. This will play an important role when we come up with rules of thumb for valuing different currencies.

With those two terms covered, we can look at how to value cryptocurrencies in general.

What factors influence a coin’s intrinsic value?

Let’s back up to our chocolate example for a minute. Pretty much everyone likes chocolate, meaning its intrinsic value is high. Yet, chocolate isn’t all that expensive. Water is an even better example. We need it for survival, yet water is pretty much free or costs very little. But something like gold, which really is only a shiny piece of metal, costs very much. So the utility of a good is not always represented in its monetary value. This begs the question:

What is a cryptocurrency’s intrinsic value, and is it an accurate way of valuing it?

how to value cryptocurrencies

There are different factors at play here. A good starting point is its utility.

Utility

What can you actually do with cryptocurrency? Well, it depends on which coin we are talking about.

Take Bitcoin as an example. Fiat money is useful because you can value and conveniently pay for things. Bitcoin can do the same. Measured according to the six factors we mentioned earlier, Bitcoin is even better. It is more durable and more transportable than bills. Plus, unlike cash, You cannot fake it, you can easily divide it into smaller units, and it is scarce.

Other coins have different utilities. Ethereum, for example, is an infrastructure that you can build decentralized applications on. The more useful apps there are on it, the more useful Ethereum itself becomes. Ripple would be another example. It’s a coin that is specifically designed to work as a payment system. It works even better than Bitcoin in that sense since it is faster and has cheaper transaction fees.

But the example of Ripple shows that there is more to a coin’s value than just utility. Like water and gold, Ripple is, theoretically, more useful than Bitcoin, but its value is lower. That’s why we have to look at a few more influencing factors.

Scarcity

Bitcoin’s supply is fixed, which is a big part of its appeal. Like gold, many people buy Bitcoin, knowing that its quantity is limited and expecting that the price will rise in the future.

But here is the key. That expectation is not self-fulfilling. It wouldn’t matter if there were only very few Bitcoin if no one wanted to buy them. Therefore, for scarcity to matter, there also must be demand for the good. The more demand there is, the more it matters that the good is scarce, turning into a virtuous circle. In its end, the good could become a store of value like gold or like Bitcoin might become.

Where then can this demand come from?

Demand in its ecosystem

One possibility is how sought-after the coin is in its own ecosystem.

Think of it like this. If you could go to Mexico and pay in dollars everywhere, you would probably do that. You would never exchange dollars for Mexican pesos because there is no need. In this scenario, the Mexican peso has no value in its own ecosystem (Mexico). So its value would probably be pretty low.

But you cannot do that. You have to exchange dollars for pesos. That is what gives the peso value in its ecosystem. In the same fashion, you might need to own some coins of a cryptocurrency to interact with its ecosystem. The more useful the currency’s project and the more useful the currency itself is, the higher its demand will be.

Perceived value (the narrative around a coin)

If it only came down to the utility of crypto projects and how much you need their native coins to interact with them, the ranking of valuable currencies might look different. However, in the crypto space, emotions and narratives play a big part in a coin’s value.

Bitcoin is the best example again. A big part of its value comes from the belief that it is valuable. A lot of people believe Bitcoin will continue to rise in value. That is why they buy. Other people argue that Bitcoin’s utility is as good as, or even better than, that of fiat money. They believe many people will eventually agree with them. Yet other people think Bitcoin will not replace fiat currency, but it has all the positive attributes of gold and none of the negative ones. They believe Bitcoin can become a store of value.

This is how the narrative around Bitcoin was created. On top of that, Bitcoin was the first cryptocurrency around and had no known founder. This lends its narrative even more power. This combination of utility, price speculation, and narrative can give a coin a very high perceived value.

For other coins, the narrative might be different. Ethereum, for example, has been called ultrasound money. Like fiat money provides the infrastructure for the economy to grow, Ethereum offers a valuable infrastructure for other projects. When valuing a cryptocurrency, the narrative and perceived value are essential to keep in mind.

Production cost

Another factor for Bitcoin, much less so for other coins, is production cost. Bitcoin requires powerful computers to perform calculations to create it. These computers require electricity to run. You could now argue that the value of one Bitcoin is equal to the cost of electricity needed to produce it.

There is some truth to that. If, for some reason, electricity became extremely expensive, maybe people would stop producing Bitcoin because they would think that the other factors don’t balance the high production cost. Or, if electricity became very cheap, Bitcoin might lose some of its value because it would still be scarce, but it would be “easier” to produce.

These are hypothetical scenarios, and it is difficult to say how much of a role this factor plays. Regardless, most other coins have only marginal production costs, so this doesn’t matter for most currencies.

Team and community

Bitcoin has no team behind it but a very active community and ecosystem. Ethereum has a well-known and well-respected team and a highly engaged community. The better and more respected the team behind a coin, the more trust they will earn from investors and their community.

At the same time, an active community is a healthy sign for different reasons. It could be that many people are interested in the coin and like the narrative around it. Dogecoin, for example, is called “the people’s coin” because of its active and massive fanbase. Another reason might be that there is a lot of development in the currency’s ecosystem happening. That is why Ethereum is much more popular and valuable than similar projects that might even be more useful. Its community is simply much more extensive.

An active community often results in higher coin value. But sometimes, there might be disagreement about the software code or how new changes should be implemented. In that case, a rift or arguments in the community can lead to a fall in the price of a coin.

Availability

Lastly, for new currencies, it is vital how easily available they are. Established cryptos like Bitcoin, Ethereum, and other big coins are available on all exchanges and sometimes even at banks. But newer or smaller currencies might only be available at a few selected exchanges. Getting listed on a more prominent exchange is a big deal because it makes it easier to acquire them and these currencies become available to a broader audience. That is why getting listed on a big exchange often goes hand in hand with a sudden price jump.

Two rules of thumb to value any cryptocurrency

The number of factors to consider might have left you feeling a bit confused. That is understandable. There are a lot of moving parts when valuing a cryptocurrency. This begs the question:

Can we break this down into a more straightforward process? Is there a “quick and dirty” way to valuing crypto?

Yes, there is.

Since cryptocurrencies are brand new, the old rules of valuing an asset are hard to apply. That’s why there are so many valuation approaches out there, but we’ll focus on the two most straightforward and intuitive ones.

Looking at a long-time average

This is the most basic yet most intuitive valuation approach. We can just look at a long enough average, draw a line and deduce the trend for this currency. Let’s look are some examples of the three coins we have mentioned so far:

Bitcoin

This is a chart with the weekly prices of Bitcoin. You can see that before 2017, the prices were so low in comparison to today that the fluctuations are barely visible in the chart. While Bitcoin has been fluctuating quite a bit after 2017, we can observe that the trend over several years is clearly up.

Ethereum

This is Ethereum’s weekly chart. As for Bitcoin, the price changes before 2017 do not even register anymore. Also similar is the massive peak the price makes before retracing and peaking again after a few years. This is a clear sign of an upward trend.

XRP

Another cryptocurrency we mentioned was XRP. This currency is younger, hence why we observe the price since its inception in 2017. A massive price appreciation with a peak followed quickly, but the price went down just as quickly. Recently, the price made another peak, but unlike for Bitcoin and Ethereum, this one was lower than the previous one. Therefore, the upward trend isn’t as evident here. In fact, you could argue that the price is not trending up at all.

So far, Bitcoin and Ethereum have been appreciating, meaning their inherent values are rising as well. But there are no guarantees this will continue in the future. This method is valuable to get a fundamental insight into how a coin is trending. But you can already see its drawbacks:

  • We can draw the lines somewhat arbitrarily.
  • We cannot infer anything about the future value of the coin.
  • We cannot compare the currencies to each other or to other assets.

That is why we need to look at another approach that considers these factors when valuing a currency.

Comparing it to similar assets

By comparing cryptocurrencies to other assets, we better understand potential growth opportunities in the future. We also make an important observation:

The price itself does not say anything about the value of a cryptocurrency.

Take gold and Ethereum as examples. As of today, the price of gold is about $1800 per ounce. The price of 1ETH is around $2000. Is Ethereum more valuable than gold? Of course not. Because remember, we have to look at the market capitalization of an asset to understand its value. Hence:

116 million ETH * $2000 = $232 billion
197,000 metric tonnes of gold * $1800 = $11 trillion

These numbers are, of course, rounded and not entirely accurate. But you can see that gold is vastly more valuable than Ethereum at this point, even with 1 unit of Ethereum having a higher price.

Now that we understand that we need to look at the market cap, we can start comparing crypto to other assets:

Crypto value v other assets

As you can see, even the value of all cryptocurrencies combined is pretty minuscule compared to the global stock market. Bitcoin, the “digital gold,” has only 5% of the market cap of gold.

Now, does this mean that crypto has a lot of room for growth? It could.

Let’s assume Bitcoin increases in popularity and more people start seeing it as a store of value (perceived value). Demand for Bitcoin increases and with it its intrinsic value. Assuming it reaches even half of the market cap of gold, that would mean a 10X increase from today’s prices. Another example could be Ethereum becoming more popular and becoming an equally important infrastructure as Google. That would imply an 8X rise from today’s prices.

This, of course, is speculation and the coins might never have this kind of intrinsic value. However, it does give you a good mental model to compare different currencies to each other and cryptocurrencies to other assets.

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