Valuing Cryptocurrencies: a short guide - Bure Valley Group

Valuing Cryptocurrencies:
      a short guide
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Bitcoin hit its all-time high of over $63,000 in April 2021,
ahead of the Coinbase debut. Ether, the second-most valuable
cryptocurrency, also hit an historic high of $2,317. Since then,
these and other cryptocurrencies have pulled back in market value
yet are still seen as valuable by many investors - with Bitcoin at
around $47,000, at the time of writing, and Ethereum $3,200.

However, for many investors who are intrigued by the potential
returns offered by these assets, the question prevails: how
does one value a cryptocurrency? With over 6,500 options to
choose from and new cryptocurrencies created every day, this is
perfectly valid to ask.

In this guide, we offer some ideas to help investors make good
valuations of cryptocurrencies to help inform portfolio decisions.

Why value?
Before diving into different ways to run a valuation, it is worth asking
why we should value a cryptocurrency at all. Generally, valuing is
done by stock market investors to try and determine the “fair value”
of a company before investing.

“Value investors” such as Warren Buffet and Seth Klarman, for instance,
have historically used the teachings of Benjamin Graham to try and
buy companies which trade significantly below their “fair value” - thus
providing a margin of safety. This helps to mitigate risk for the investor
whilst providing a firm justification in his/her mind for holding a stock
over the long term, as its value oscillates.

Other investors - e.g. “growth investors” - are not so concerned with
buying discount stocks, but use valuation methods to predict future or
potential market prices. Different methods are used by various stock
investors such as the P/E ratio and discounted free cash flow. The issue
with cryptocurrency investments, however, is that most of these methods
do not work.

Cryptocurrency valuation challenges
Cryptocurrencies do not have a balance sheet, income statement or other
financial statements.

They do not have cash flow, inventory and other traditional aspects of a stock
which can help an investor make a valuation using discounted free cash flow.

There are also no shares being issued, so a P/E valuation is also impossible.
Cryptocurrencies also do not fit neatly into other asset types.

For instance, they cannot really be called currencies because they go beyond
the purpose of simply exchanging value.

Moreover, they cannot be deemed commodities because they are not
consumable (like oil or wheat) and lack physical attributes (e.g. gold).

How to value cryptocurrencies
Suppose you want to know how much 1 Bitcoin is really worth (i.e. the fair
value) before putting your hard-earned wealth into investing in it. How do
you do this? Fortunately, there are some useful approaches which are at
your disposal.

These include:

Utility
How useful is the cryptocurrency in question? This largely relates to the
blockchain technology upon which it is based. Ether, for instance, gained
success largely due to the growing usefulness of its smart contract technologies.

Perceived value
This starts to get at the idea of branding. What kind of reputation does a
cryptocurrency have? Does it even have one in wider society, and if so, is it
positive or negative? If there is widespread interest and good sentiment, this
can create value.

Scarcity
In any economy, a problem-solving product or service becomes more valuable the
more rare it is. If a cryptocurrency is highly desired and in limited supply, then its
value is likely to be higher.

Geopolitics
In many countries, various cryptocurrencies have been banned - perhaps due
to their perceived threat to the state - or are increasingly regulated. Others have
not been adversely affected and may even be looked upon favourably by those
in power. In El Salvador, for instance, the government recently adopted Bitcoin
as legal tender.

Versatility
Can the cryptocurrency be used by many merchants and buyers across the
world? If not, does it have the potential to? Can its technology adapt and
improve with new consumer demands?

One fund manager - ARK Investments - has used these types of criteria to
develop their own cryptocurrency valuation model. This is called the Equation
of Exchange and is expressed in the formula MV = PQ.

This takes the following into account when valuing crypto assets:
M = Size of the asset base.
V = Velocity of the asset.
P = Price of the digital resource being provisioned.
Q = Quantity of the digital resource being provisioned.

                   GEOPOLITICS

                                   SCARCITY

             Utility

                         PERCEIVED VALUE

                                                      VERSATILITY

Stock valuation methods can still be
useful
Investing in cryptocurrencies does not need to just involve buying some
directly (e.g. Bitcoin), holding it and then selling it for a profit later.

In particular, you could aim to invest in companies which mine
cryptocurrencies or which have exposure to cryptocurrencies.

The benefit of this approach is that these companies can be valued using
the aforementioned stock methods - e.g. discounted free cash flow, price to
earnings (P/E) and price to book value (P/B).

This can be a great way for value investors to gain exposure to crypto, for
instance.

A business may be especially attractive if it can demonstrate stable financials
over time and has other routes for generating revenue if a particular
cryptocurrency falls dramatically in value.

What affects the price of crypto?
Whilst it is impossible to predict what will happen with price movements
for these investments, there are ways to identify prominent influences on
cryptocurrencies which can give an indication of where prices may be going.

These include:

Political and economic events
Sometimes a government decides upon an action which causes a huge sway in
cryptocurrency prices. Recently in 2021, for instance, China has cracked down
heavily on crypto operators like Huobi Mall and BTC.TOP in provinces such
as Sichuan.

Regulation changes
In the US, for example, debate is raging about whether to introduce stricter
“know-your-customer” and anti-money-laundering regulations for crypto
exchange and platforms.

Prominent people and institutions
In early June, Musk posted on social media that the “dogecoin standard”
is “inevitable”. This - along with other influences such as Coinbase adding
Dogecoin support to its platform - was credited by commentators as the main
driver behind the cryptocurrency’s 20% rise within the next 24 hours.

New entrants
When a particular cryptocurrency gains popularity, it is common to see money
flow into it from other ones. This can create a “tidal effect” with investors’ capital,
and with new crypto options being launched daily it can also lead to dilution.

Hacking
The likes of Bitcoin are still largely traded on cryptocurrency exchange
platforms like Coinbase, which can be vulnerable to malicious actors and code.
In 2018, for example, Binance spotted some strange activities on its platform
and suspended withdrawals. It found unauthorised sell orders taking place, and
it looked like a 3rd- party app using an API to control Binance accounts was to
blame. Within minutes, Bitcoin plunged 10.8%, from $10,740 to $9,690.

Cost of extraction (mining)
If input costs become unviable for miners, this can lead to a price drop as they
move to other, more profitable cryptocurrencies. Another factor that impacts mining
scalability is the supply of crypto mining hardware. GPUs and ASIC devices, for
instance, can sometimes be scarce due to very high demand from miners.

Speculation
So much investment activity on the stock market - buy and sell orders - is
driven by institutions and individuals “guessing” what will happen to certain
stock prices. When enough people are influenced by these speculations, it
can create a “herd mentality effect” where more and more investors want to
follow the crowd out of fear of missing out. A similar dynamic occurs within
the crypto markets, leading to a rapid rise - or deflation - in asset prices
depending on what people are saying.

Conclusion & invitation
If you would like to find out more, then contact Bure Valley
Group and find out what opportunities are out there for you.

Professional Guidance
Whether you are a professional investor with years of experience, a curious spectator looking to know
more, or someone who is preparing to take the plunge in to an extremely exciting space in the UK,
then it is always advised that regardless of experience, you seek expertise.

Bure Valley group has been supporting the growth and
development of businesses and investors for many years,
covering traditional and emerging sectors.

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