In October 2021 Bitcoin reached an all-time high of US$65,000. Despite their potential value, cryptocurrencies are complex, challenging, and controversial investment assets. How we determine a crypto asset’s worth and potential is still an ongoing discussion. Here are five ways to evaluate crypto assets and their potential as investment opportunities.
- The size of the available market potential
One of the most popular ways of valuing crypto assets is by estimating how accessible the market is and making comparisons with the current estimated market capitalization. For example, many people argue that Bitcoin is an investment that is similar to gold in that it stores value that grows continually.
This can be described as if the current gold price is at $2000 per ounce, then the gold stock that has been mined in the world has reached $13 trillion. As for Bitcoin itself, its maximum supply on the market is 21 million coins. So in this case, the comparison between gold and Bitcoin is invalid in terms of storing the value of the asset itself. For example, if the value of Bitcoin reaches $620,000, then Bitcoin will only touch the figure of 2% of the total capitalization of gold in the world.
The advantage of this approach is the simplicity of the logic behind it. This approach makes it easy to understand the value of crypto assets and also provides a strong framework for comparing cryptocurrencies against other markets.
- Using the formula MV=PQ
One of the crypto valuation alternatives that is widely discussed by experts was first proposed by crypto researcher Chris Burniske and Jack Tatar, managing partner of Doyle Capital, in a book entitled ‘Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond’.
Their framework is famous for the formula that is the basis for valuing their crypto assets, namely: MV = PQ. The formula is borrowed from a traditional model used to value currencies and is drawn on the assumption that its value is related to the size of the supported market as well as the speed with which the market moves.
Here is an explanation of the formula above:
- M = Amount of currency in the market
- V = Average frequency of one unit of money spent
- P = Prices of goods and services
- Q = Quantity of goods and services
As an easy example using integers, let’s assume that Bitcoin processes 100 billion transactions (Q) at a price of $100 (P) each year. Then PxQ = 100 billion x $100 = $10 trillion per year. If the velocity of this asset is assumed to be 5, we can conclude that the potential market capitalization of $10 trillion per year divided by 5 is $2 trillion.
If we divide this number by the total number of Bitcoins in existence, which is 21 million, then the potential value of Bitcoin is $2 trillion divided by 21 million, which is $95,238 per coin. If we think that this figure can be achieved in the next five years, then we can estimate the average value in the present. However, this approach is limited due to the difficulty of calculating an asset’s velocity.
- Valuing crypto assets as a network
A third way of valuing crypto is through Metcalfe’s Law, a technological theory which states that the value of a network is proportional to the number of participants squared. If you consider social media like Facebook, Instagram, or Linkedin as examples, then the value of one user is zero. But when a second user is added, the network becomes valuable. As the number of users on the network increases, its value also grows.
In using this method, the value of the network is not judged by the number of users, but by the square of the ‘value’ of one user. If each user is considered to have a value of 5, then the network value is the square of that number, which is 25. This theory has been widely used in assessing social media networks and is considered highly accurate.
- Rating based on production price
The value of the production assessment was taken from a thesis submitted by Adam Hayes in 2015 and has been disseminated by many researchers since then. The theory put out is that crypto, like any other commodity, is subject to the traditional supply-side price-loading challenge.
Crypto miners, the owners of computers that process transactions on their network and profit from them, spend traditional currencies to produce a margin of crypto assets. Hayes argues that if Bitcoin is valued as a commodity, then the cost of producing each Bitcoin must match the price of the asset itself.
However, if Bitcoin mining becomes unprofitable, then miners can easily shift their attention to other assets or even leave the market entirely. As a result, the value of each Bitcoin can be estimated by examining the margin cost of the mining itself compared to the expected yield.
- Calculating value based on scarcity (stock-to-flow model)
The final approach is the stock-to-flow model which was first published in 2019 in a paper titled ‘Modeling Bitcoin Value with Scarcity’ by PlanB, a crypto research bureau under a pseudonym. In this model they state that the value of Bitcoin is a reflection of its limitations and that it can be measured by the ratio of the existing stock, a relationship between the current value of the asset, and the number of Bitcoins produced each year.
This research shows that the value of Bitcoin has historically shown a close correlation with increasing scarcity as described in this theory. However, this theory is only intended for Bitcoin assets and is used by those who see scarcity as the dominant characteristic of an asset.
Reference: https://www.cfainstitute.org/-/media/documents/article/rf-brief/rfbr-cryptoassets.ashx
