This article outlines some of the inherent difficulties in valuing crytpo assets. I will predominantly focus on bitcoin, but the logic is valid across most cryptocurrencies. This is the first of a series of articles that will attempt to apply some traditional financial analysis to the problem of valuing bitcoin and other altcoins. Whilst a traditional application of many financial analytical methods is difficult in the crypto space, I still believe that the underlying philosophy of traditional fundamental analysis can be applied to currencies such as bitcoin. In this article I will start by discussing why I think many of the resources currently available on Reddit and Youtube are not particularly useful to the average crypto currency enthusiast. I will cover some traditional financial metrics and why these types of metrics don’t work in the crypto currency space, and I will also cover some traditional metrics that can be applied. I will then give an example of one possible method of valuation for bitcoin to demonstrate the ways in which these types of methods can be used to give an indication of price.
I will start the article by stating that I am not in the business of generating price targets for specific currencies. There are a large number of resources available not only on Steemit, but also on the broader internet that will provide any number of predictions as to how valuable a particular currency may be. My biggest problem with many of these resources is that they are based on what I would call the ‘I reckon“ factor.” Most of the authors simply select a particular currency and then base their estimates on their general gut feeling as to the direction in which that currency might move. “I reckon this particular currency going to $X” is how I would paraphrase many of their arguments. Most of these valuations have absolutely no underpinning in fact, or any serious analysis behind them. Whilst I think it’s impressive that many YouTube producers are able to speak for 8 to 10 minutes on their valuation of a particular currency without providing any factual information, the opinion they provide is of little use to the average crypto investor when determining whether a particular currency is worth investing in. It is not uncommon to hear an analyst make a statement such as
“You just gotta get on board with this currency. It’s cheap. It’s going to $10”
At no point does the analyst provide any reference as to how he came up with a valuation of ten dollars, or what he thinks might drive the currency to achieve this price target. Why 10 dollars instead of 20 or 5? Some of these guys are extremely successful, with large numbers of YouTube followers. More power to them if they can achieve their objectives with the generation of material of this kind. For the serious crypto currency investor however, these types of analyses are next to useless. My aim in this article is to put a bit more meat on the bone in terms of valuation of currencies, and allow my readers and followers to make some educated decisions about which currencies they think are most likely to appreciate in value.
I don’t think it’s possible to accurately provide price targets for crypto currencies at this point in time. I think that crypto markets are too immature, and information is too scarce for anyone to be able to calculate an estimated value for such an intangible asset. This does not mean that attempts to value currencies are worthless however. They are just imprecise by nature.
The first crypto currency was only invented in 2009. If you step back from crypto currencies for a second and consider broader financial markets you will see that there is well over 200 years of study, research, and analysis of financial assets that have led to some of the very sophisticated models that allow todays investment market participants to provide price targets with some level of confidence. Some of the smartest minds in the history of humankind have applied themselves to this field. That’s not to say that these valuations are always correct, but when one considers the body of work that has gone into modern mainstream financial theory it at least allows a mainstream financial analyst to base his or her estimates on some tangible basis. Think what you like of mainstream finance and the participants in this particular industry, but it’s undeniable that some very bright minds have applied themselves to this discipline and that there is some value in the body of work that they have produced.
The problem is that many of the methods that they have developed to value traditional assets are not applicable to crypto currencies. That said it is possible to use certain fundamental methods to determine whether a particular currency has value and to get an idea of how that value might translate into real-world dollars.
The most common method of valuing a financial asset in use today is some form of cash flow valuation method. This is applicable whether you consider a stock listed on the New York Stock Exchange, a bond issued by a sovereign government or a term deposit issued by your local bank. Even traditional bank savings accounts provide a small rate of return which allows you to determine whether this particular investment is appropriate for your needs and will give you the returns that you seek. Stock market analysts use methods such as discounted cash flows and price earnings ratios to determine whether stocks are undervalued or overvalued. Even bond investments are predominantly valued based on the amount of interest (the coupon) that they will pay over the duration of the bond. Crypto currencies on the other hand do not generate income. There are some exceptions to this, and with increasing interest in proof of stake as a network confirmation measure there is potential that cash flow valuations will become more reliable into the future. Currently however most crypto currencies do not generate income, meaning that the most common tool for valuing a financial asset is of no use to us. Even those currencies that do generate an income do not generate stable incomes as many involve increasing difficulty levels which reduces the stake reward over time. Whilst it would be possible to construct financial formulas that take these factors into account, I think it is also necessary to recognise that the vast majority of crypto currency investors are not investing for the purpose of generating income. Most investors seek capital growth. So that’s our first problem outlined. Traditional cash flow-based methods of valuation are inapplicable in the crypto currency world.
The next problem with valuing crypto currencies is that they have no inherent value. I realise this argument is likely to be contentious given that the majority of my readers are undoubtedly crypto currency enthusiasts. At their heart though, crypto currencies are nothing but lines of code or put another way, sequences of ones and zeros in the electronic language. They don’t exist in any real sense and are not able to be used in any way other than that which they were designed for. A piece of wood has value because it can be used to build a house or create a woodcarving or create a piece of furniture. A piece of steel has value because it can be turned into a car or a desk or a heater, or any number of other things. Even a second-hand car has value because it can be stripped into parts to be recycled or sold as spares for other vehicles. Crypto currencies share none of these attributes. Even the granddaddy of all crypto currencies, Bitcoin, suffers from the same shortcomings. Bitcoin itself has no value. The block chain has value and the innovations that it allows certainly has value, however the currency itself in isolation of this block chain is completely worthless. If at some point another crypto currency comes along that is able to supplant bitcoin and provide the same utility but in a more efficient manner then bitcoin will be rapidly be superseded. This is very essence of technological disruption. There are many coins on the market currently seeking to do this and at some point one of them is likely to be successful. So for all that bitcoin today dominates the crypto currency market capitalisation, there is no guarantee that this will continue into the future. There is a very real risk that your bitcoin holdings could be worthless at some point in the future. Please note that this is not a prediction. It is simply a discussion of a hypothetical concept. I currently own bitcoin and intend to continue to own bitcoin until a more suitable alternative presents itself. The problem remains though. If an asset has no intrinsic value, how do we determine an appropriate price for it.
My next article will deal with this issue in some greater and provide an example of how might apply a logical and consistent method to the valuation of crypto currency.
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