Here Are Some Ways a Cryptocurrency’s Value Can Be Calculated

Institutional investors remain interested in cryptocurrencies despite the widespread selloff that has struck the sector this year. In fact, Fidelity’s fourth-annual Institutional Digital Assets Study found that more than half of respondents had invested in digital assets during the first six months of 2022. Nearly three-quarters of the institutional investors surveyed plan to invest in the future.

How Much is Cryptocurrency Worth?

As the total market capitalization of the entire crypto market flirts with a return to $1 trillion, the market faces a specter that has hovered over every other asset since trading began: valuation.

Experienced investors and institutions always want to know what an asset is worth so that they can determine whether the current trading price is attractive.

However, this is a problem with cryptocurrencies because they have no cash flows, earnings, or any other metrics typically used to value companies. As a result, many continue to refer to bitcoin as “digital gold” because gold’s price is driven by other factors, including supply versus demand, the size of reserves held by central banks, and the value of the U.S. dollar versus other fiat currencies.

Unfortunately, even these alternative methods of valuation become tricky for most cryptocurrencies. As a result, many crypto experts have sought to establish their own methods of valuation, one of which was set out by crypto exchange-traded product issuer 21Shares in a recent report entitled “State of Crypto.”

The ETP issuer divided the primary frameworks it uses to value cryptocurrencies into two approaches similar to how institutions value other assets: fundamental or intrinsic valuation and relative valuation. The former utilizes discounted cash flow and mining production costs, while the latter is composed of multiples and market sizing.

Why Different Methods Should Be Used

According to 21Shares, the valuation method used depends on the type of crypto asset being valued. While fundamental and relative valuations can work for all crypto assets, the valuation method used should differ based on the consensus mechanism, usually proof-of-work or proof-of-stake, and the type of token, which can be governance, utility, or non-fungible tokens.

For example, a cryptocurrency’s mining production cost is critical when trying to value PoW assets like bitcoin. Other factors that apply to PoW assets include market size and multiples. On the other hand, PoS assets like ether, governance tokens like MakerDAO, and NFTs may be better valued using an intrinsic valuation derived using a discounted cash flow method.

Finally, all crypto assets, including NFTs, can be valued using relative valuation methods like multiples and market sizing.

Intrinsic Versus Relative Valuations

When trying to determine the valuation of any crypto asset, it’s important to understand the differences between intrinsic and relative valuations. Intrinsic valuations connect an asset’s value to its capacity to generate cash flows, which is then adjusted for timing and risk. One benefit of these methods is that they are less exposed to market sentiment, while another is that they force investors to think about the asset’s fundamentals.

However, intrinsic valuation methods also require more concrete data that can be difficult to estimate. Additionally, intrinsic methods can only be used on assets that generate cash flows.

On the other hand, relative valuations are assigned based on what investors are paying for comparable assets. These methods involve using multiples, which are a standardized estimate of the price, and the size of the total addressable market.

Using relative valuation methods is beneficial because it places investors in sync with the overall market sentiment and because any asset can be valued in these ways. Additionally, relative valuation methods don’t require very specific information.

It’s also important to note that crypto assets can seem undervalued on both a relative and fundamental basis.

Price Versus Value

Investors buy and sell assets because the general agreement is that the market is inefficient on some level. If markets were totally efficient, an asset’s price would match its value, eliminating the need to determine its value at all.

New York University Professor Aswath Damodaran defined a clear distinction between value and price. Fundamentals like cash flows, growth, and risk drive an asset’s value, while market sentiment, narratives, and liquidity drive its price.

As far as valuation approaches, fundamentals drive intrinsic valuations while ignoring the market dynamics. On the other hand, market sentiment and momentum drive relative valuations. As a result, relative valuations can help investors determine if a particular asset is undervalued relative to its peers and whether it is historically undervalued or overvalued based on indicators like the price-to-sales ratio.

These factors show that market cycles fluctuate between safety and risk capital. For example, periods of abundant risk capital trigger times of “irrational exuberance,” which send prices to exorbitantly high levels on a relative basis.

On the other hand, investors avoid riskier assets when there’s no risk capital, seeking safety instead. History has shown that assets without any objective measure of value with a limited supply are more subject to irrational exuberance, just as crypto assets are today. Thus, crypto assets are often bid up to unsustainable levels during periods of abundant risk capital.

Why PoS Cryptocurrencies Have Cash Flows

The 21Shares team goes even further by categorizing crypto assets into three groups: capital assets, which are similar to stocks and bonds, consumable assets, which can be consumed or transformed into something else, like commodities, and stores of value, which include gold. PoW crypto assets are grouped with the consumables, while PoS crypto assets are considered capital assets.

Some of the confusion about valuing crypto assets is the fact that many of them have characteristics of all three asset classes. For example, 21Shares argues that a discounted cash flow model, which is often used for stocks, is the best way to value PoS cryptocurrencies.

Many have said over the years that crypto assets have no cash flows, but that’s certainly not true of PoS cryptocurrencies. For example, investors can estimate ether’s cash flow by equating the dividend yield of a company with ether’s staking yield.

Transaction fees in the network are paid to stakers and are sometimes considered a proxy for revenue. However, when new tokens are issued, it doesn’t dilute stakers’ holdings. Instead, it adds to their holdings, and in a PoS network, they have a right to those new tokens.

Additionally, the number of staked tokens as a percentage of the total circulating supply determines the staking participation rate. An increase in this rate typically decreases the staking yield and vice versa.

The resulting formula to determine ether’s cash flows to validators is the value of transaction fees they earn plus the tokens issued in exchange for validating transactions. Additionally, the staking yield is the annual cash flows to the validators divided by the number of staked tokens.

Other variables required in determining a discounted cash flow valuation include the asset’s estimated lifespan, which is generally perpetuity (with 10 years used as a proxy), and the discount rate, which reflects the perceived risk.

Final Thoughts

Only time will tell how institutional investors will choose to value crypto assets before determining whether they are undervalued or not. However, it seems likely that some combination of the methods discussed here will become the consensus eventually.

This article originally appeared on The Tokenist

By Michelle Jones