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Investing in cryptocurrencies is a wild ride. There is obviously a lot of speculation involved but my question is another one: what are good models to evaluate the fundamental value of cryptocurrencies? Does it help to price them as you would price traditional currencies or are they fundamentally different? If so, why and how?

I am interested in serious research on the topic.

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  • $\begingroup$ One factor, I think, is to consider the total energy put into a currency through mining. In that sense proof of work currencies are worth more than environmentally-friendly alternatives. $\endgroup$ Jun 1 at 8:44
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    $\begingroup$ @user2520938 i think the total cost of energy are some sort of sunk costs that shouldn't matter for pricing.. $\endgroup$
    – T123
    Jun 1 at 9:57
  • $\begingroup$ @T123, Maybe... Although the fact that e.g. bitcoin in theory has some legitimate uses and is an interesting technology, it only seems reasonable to take the costs of "producing" the technology/product into account when pricing it. $\endgroup$ Jun 1 at 10:00
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    $\begingroup$ @user2520938 I guess if we think of production optima, the suppliers price at least could be determined by MC=p, where the marginal costs could be something like the energy costs required (expected) for mining the next coin.. just a thought.. however, we still need to figure out the demand side where mutility=p should hold.. then we can solve for the market clearing p $\endgroup$
    – T123
    Jun 1 at 10:49
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    $\begingroup$ @vonjd: Yes that is true, there is no deterministic way to calculate a total network hash power, that is the one variable that cannot be measured. The other variables such as next block time, tx fee rewards, price would all be random variables but could possible be modelled. $\endgroup$ Jun 2 at 15:39

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Having been to a Business school (not sure whether that's a badge of honor or a badge of shame :), I've covered the "established" valuation models, from comparative analysis, to DCF, to CAPM, to derivative pricing, etc.

When it comes to crypto, I think common sense has to prevail: no "mathematics" can possibly tell you how much some coin should be worth.

I would classify crypto into three distinct classes:

  1. Companies, that have some tangible product, but chose to gain market cap via an ICO, instead of an IPO (for example Bankera, represented by the BNK token). In cases such as Bankera, the token cannot be mined, there is a limited supply, and therefore a traditional valuation should work; either we can try to forecast the cashflows generated by the company and try to use DCF or we could even use multiples and treat it as an equity. Obviously, massive discount should be applied since the company didn't go through the rigors of an IPO, doesn't need to publish quarterly reports, doesn't need to be audited, etc.

  2. Smart contracts (such as Ethereum, represented by the ETH token). The value here is in the network (public ledger) that manages the smart contracts, including irreversible transfer of ownership, for which it charges fees ("gas"). DCF could possibly be used here together with some guesstimate on the future demand for the network services. Note that the smart contracts on the network might have some intrinsic value, not related to the ETH "coin" itself: the value of the coin is in the "gas" fees that the network generates.

  3. "Currencies" (such as Bitcoin, represented by the BTC token): here, the value of each token is clearly driven by pure supply and demand, with no clear intrinsic value (one could argue that the floor should be the cost of the energy needed to secure the network, but I don't see that as a valid argument: I can run an expensive supercomputer to try to solve some "useless" cryptographic problems, and the cost of doing that won't necessarily generate "value"). In a way, the value of BTC is based on "trust" in the purest sense of the original meaning of the word "credit" from Latin (meaning to "trust"): when you accept BTC for goods or services, you absolutely have to trust that you will be able to use it in the future to buy other services or goods if you ever decide to: since BTC is not backed by any government or a central bank (except for El Savlador) and cannot be used to pay for taxes, it's value cannot be treated as a traditional currency: instead, it is simply "credit" in the purest sense.

That's my two cents.

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Investing in cryptocurrencies is a wild ride. There is obviously a lot of speculation involved but my question is another one: what are good models to evaluate the fundamental value of cryptocurrencies?

One of the best models to value anything is (modified) discounted cash flow. Note that there can be other models, but this is easy, understandable and proven.

Eventually, any value above immediate consumption is discounted future cash flow and its growth. If there is no cash flow, there is no future economic value, outside scarcity that can be artificial (Bitcoin) or true (oil). The trick is that a lot of cryptocurrencies go to the great lengths to mask the revenue share of this cash flow to cryptocurrency holders to avoid pissing off Mr Gary Gensler of the SEC, or any other head honcho regulator.

For example, Ethereum ETH native token will share profits with its owners via its burn mechanics. Unlike Bitcoin which is not a yield generating asset, ETH holders will directly benefit from the transaction fees, which will be distributed to the holders in the form of ETH burn - a somewhat similar mechanism to stock buybacks.

Some tokens have a direct revenue share with stakes. These include Curve CRV, Sushi xSushi, and so on. This could be close to equity and dividends, and a hotbed in securities regulation in some jurisdictions, but there is very little that can be done to stop investors to invest in them. Stopping founders/companies are a different matter but most of the blue-chip decentralised protocols are "unstoppable" - after started, the machine will never stop barring the catastrophic failure of the underlying blockchain protocol.

Some old cryptocurrencies like Bitcoin base their success on the fact that maybe they will be used as a reserve currency and have thus value like the US dollar has today. Today, there is evidence that Bitcoin is becoming attractive to developing nations. However, Bitcoin is not a productive asset and outside its trust value, which comes with its age (trust can be only earned over time), it is not a productive asset. Whereas all decentralised applications built on the top of Ethereum network will yield profit to Ethereum holders.

Furthermore, you can stake your cryptocurrency, like in the case of ETH. In this case, you will put your asset to work to secure the network. The downside is that if you screw up, e.g. by staking with an incompetent service provider or messing up yourself, you get slashed. I do not know if there is an analogue for staking in traditional finance - it would be something like a silent partner in a company, but the forecast of the future revenues are very easy to model mathematically.

If you want to start researching the topic, some of the best sources are venture capital firm blogs that publicly analyse their investments, assets and the investment landscape. I recommend Sigil Fund blog. (Disclaimer: I am LP).

Also, besides the asset being productive itself, you can make yield by borrowing it from the short-sellers for relatively low risk. For example, Aave lending protocol allows you to do this for relatively easily modelled risk (read: low risk).

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  • $\begingroup$ Thank you. So, based on cash flow Bitcoin would fundamentally be zero (?), and Ethereum? Could you give an estimate? $\endgroup$
    – vonjd
    Jun 2 at 8:32
  • $\begingroup$ What is an LP?. $\endgroup$ Jun 2 at 9:34
  • $\begingroup$ Limited partner. $\endgroup$ Jun 2 at 10:24
  • $\begingroup$ @vonjd if you want a fair price for Ethereum I believe that's another question, not a comment :) $\endgroup$ Jun 2 at 10:24
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Take a look at PlanB@100trillionUSD's article on the Stock-to-Flow (S2F) model.

In short, the idea is that the value of bitcoin is tied to its scarcity, which can be quantified by Stock-to-Flow $$ SF_t := \frac{stock_t}{flow_t} = \frac{\text{total number of outstanding bitcoins}}{\text{annual production}}$$, which can be seen as how many years it would take to reach the current stock at the current production rate. That is, if it takes a long time to replenish existing stocks, it is a scarce resource.

For bitcoin, new coins are mined at a rate that is halved every four years. Back in 2019, the current stock of bitcoins was $stock_{2019}=17.5m$ coins, and $flow_{2019}=0.7m$ new coins were mined, translating to a Stock-to-Flow of $SF_{2019}=25$

Now the idea is that the total market value of bitcoins is related to its scarcity, or its $SF$. Regressing $ln(\text{market value}_t)$ against $ln(SF_t)$ reveals an approximately linear relationhip. From here, we can back out the price and make future predictions. E.g. with the model from February 2019 and spot price of 3-4k USD at that time, it was predicted that the price in 2021 woukd be ~50k USD, which happened to be not too bad a prediction. Obviously, in the current inflation climate with the current BTC spot at 21k USD (15 Jun 2022), we can simply conclude that the model is wrong, like all models, but that it certainly might be useful.

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The current paper (June 2022) "An Investor’s Guide to Crypto" from several authors from Duke University and MAN Group (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4124576) provides a good overview of valuation methods:

  • The value of a network is proportional to the square of network size (Metcalfe’s Law). However, the proportionality coefficient is unknown and likely varies across crypto-assets.
  • Bitcoin is a digital mirror of physical gold, which historically constitute about 3.4% of global wealth (about \$446 trillion at the end of April 2022). Assuming the shares of this allocation should be 90% for gold and 10% for bitcoin, implied valuations are \$1,270 per ounce for gold and \$72,270 per bitcoin.
  • The value of bitcoin should be a multiple of its mining cost. If the multiple were to settle around historical average levels for gold, copper and oil (about 1.5x), bitcoin should be worth about \$11,450 as of the end of April 2022. However, physical mining is highly capital-intensive, whereas bitcoin mining is not.
  • The value of crypto-assets is related to the inverse ratio of new unit creation to the total units outstanding. This ratio is very low for bitcoin and ether compared to leading fiat currencies, suggesting substantial appreciation for the former. However, the ratio for bitcoin will eventually go to zero, implying infinite valuation.
  • The relative value of crypto-asset spot and futures/forward prices indicates current undervaluation or overvaluation. However, this approach says nothing about fundamental value.

(Source: https://www.cxoadvisory.com/currency-trading/crypto-investing-guide/, behind a paywall).

Another, older paper, is also interesting in this context:

Bernardi, Daniele and Bertelli, Ruggero, Bitcoin Price Forecast Using Quantitative Models (March 21, 2021). Available at SSRN: https://ssrn.com/abstract=3879700 or http://dx.doi.org/10.2139/ssrn.3879700

From the Abstract
What is the “fundamental value” of Bitcoin?

In this paper we aim to build a framework that permits to answer this question.

First step of our framework in based on “The value of scarcity”. The concept of scarcity is well present and known in Commodities, such as with Gold, Silver, Palladium or Platinum.

These precious materials are all the more precious the more scarce their production is.

In fact, there is a mathematical model known as Stock to Flow, that estimates price based on the quantity already present in the world (Stock) with the quantity that is extracted every year (Flow).

Second step is explaining the “bubbles” (or the “waves”, considering Shiller’s narrative environment) in a fundamental picture based on the “halving rule”.

Third step is the determinants of the Bitcoin demand and price. The “rate of adoption” model.

Fourth step is the “cost and revenues of production” model based on mining process, and the hash rate. The supply chain of bitcoin model is built to create price growth.

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    $\begingroup$ "Bitcoin is a digital mirror of physical gold" is a belief statement, not a fact. It would help if they were correlated in reality. $\endgroup$ Jul 2 at 6:14
  • $\begingroup$ I agree, yet it is one of the approaches often used. $\endgroup$
    – vonjd
    Jul 2 at 10:03

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