Valuing Cryptocurrencies - An Approach

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There are well over 1,000 cryptocurrencies floating around right now, and it’s my sincere belief that many, if not most of them, will fail. This becomes especially evident when a little bit of thoughtful research is done, and one sees that many of them either have no realistic plans for success (beyond a pump-and-dump of the coin), and/or offer no meaningful value that is not already well represented in the crypto-space.  So how to tell them apart? Well, I’ll share my personal approach, which I hope you find interesting and maybe useful. I suspect that applying this methodology might lead one to ‘miss out’ on some rip-roaring rally on a coin that might otherwise have been speculated in, but hopefully it will also keep one from waking up one morning to discover the coin thought to be a sure thing for a quick in-and-out trade has dropped precipitously in value. Different people need different things to sleep at night. Diff'rent strokes for Diff'rent folks. 

Step 1: Ask (and attempt to answer the question) – Is the goal of this cryptocurrency to be considered money? In other words, does the coin hope to be considered a broad and fundamental unit of money/currency that will be used to effect value transfers?

The primary examples of coins that attempt to ‘be money’ are:

Bitcoin, Bitcoin cash, Litecoin, Dash & Monero.

The goal of eventually becoming money is potentially incredibly valuable. The prize is the displacement of a significant percentage of existing forms of money (namely, Fiat currencies issued by governments, whether they be dollars, euros, yen, etc.) and that achievement would be stupendous in its implications – both socially and financially.

The current measure of all transactional ‘money’ in the world (an economic measure called M3) is approximately $80 trillion. If any one of the 5 coins above mentioned are to be successful as ‘money’ and garner a significant share of M3, it would have astounding implications for the value of the coins. The (very rough) table below shows that ‘upside’ from current values should the individual coins achieve a 20% of M3 ‘market share’ range from ~50 times current value for Bitcoin, to over 2,600 times current value for Monero. This is in stark contrast to coins that do not aspire to be money which we will explore shortly.

(Please excuse the horrendously scrappy cut/paste for the below table.. the gist of it should be clear though)

So now we come to a fork in the road – was the answer to Step 1 a ‘yes’, or a ‘no’? If ‘yes’, then proceed to Step 2. If ‘no’, proceed to Step 3.

Step 2: Check the coin under consideration for its current and prospective ability to satisfy the criteria of ‘moneyness’.  

I won’t go into a full re-hash of the concept of moneyness here, as you can read plenty about it in TPOM and The Bitcoin Flaw, but in short, the coins need to satisfy the 4 main aspects of sound money – Store of Value, Unit of Account Medium of Exchange and Fungibility[1].

We check for its moneyness under the simple premise that if a coin lacks any critical aspect of moneyness, it will ultimately fail and hand the mantle of ‘money’ over to a coin that succeeds. My take on all the above mentioned coins (in case you didn't know) is that i far prefer Monero as the best candidate. In any case, you can decide for yourself and are free to disagree and/or hedge your bets.

The math though for valuation in this scenario becomes trivial (although determination of input values is not). If the coin in question passes the test for being surviving money, then we may apply the valuation technique as {[Expected % of M3] x [M3 Value] }/ [number of coins outstanding].. all present-valued.

Step 3: Determine what value is being created by the coin and/or coin ecosystem.

*Note: you should only be here in step 3 if you answered no to the question in Step 1. I realize that some people might make an argument for ETH being in both places, but I disagree for reasons I won’t expand on here. Feel free to email me if you’d like to discuss.

Since the coin we are now looking at is not a ‘money’ prospect, we can apply much more traditional valuation metrics – without needing to understand some bigger-picture and subtler aspects of global macroeconomics. Hooray!

We simply need to ask, what value is being created?

Let’s take what has been a contentious coin for me as an example: Ripple (technically XRP, the coin).

Ripple, as a medium of exchange that can facilitate lower cost cross-border transactions, offers the prospect for enormous value to be released. After all, there are many billions of dollars currently spent (and arguably wasted) in the current archaic and cumbersome international money transfer market. We can even ascribe theoretical dollars to it, so let’s do that:

Let’s say the Annual cross-border international transfer market is $200 trillion annually, and let’s further assume the average fee savings by replacing the old archaic systems with the disruption of blockchain-type processes will be a clean 5% - that’s $10 trillion a year!

So maybe this mean that Ripple’s coin, XRP, if Ripple were to garner a 100% market share should be worth $10 trillion?! Not so fast there cowboy.

Now that we’ve identified the potential value-creation/release aspect, we need to make a critical next-step jump – and this leads us to Step 4. Of course, if we haven’t been able to identify any monetary value being created at all, we can stop here and most likely abandon the coin from consideration.

Step 4: Ask – To WHERE and/or WHOM does the value created in Step 3 Accrue?

In Ripple’s case, most of the value accrues to two parties – competitive pressures will see to that – either the banks themselves who no longer have to bear the cost-burden of an antiquated system, or the customers who will experience much lower costs and fees.

But wait a minute – we are valuing a coin here – so the real question (between the lines) is something a little different.. let’s make this our step 5.

Step 5: Ask – How does value created by the coin/ecosystem/etc. necessarily accrue to the coin under question? And by how much?

Let’s stick with Ripple for the example.

I’ve never argued that Ripple wasn’t a good idea. While I still question the uptake and competitive response, and many people have enjoyed an ‘I told you so!’ after a few recent announcements and a big price move – I have yet to hear anyone address this Step 5 question (even though it has been asked of some people who claim to be the experts).

Just because a coin/currency/etc. creates value as a whole, for an investment in the coin to be based on solid fundamentals, there has to be a demonstration as to why the coin needs to be worth more.

Good news for XRP investors – I definitely see a scenario where it needs to maintain a value. The (potentially) bad news – that value could be a lot lower than current levels.

Rather than rewrite it, I’ll just quote my other post (the Postscript to ‘Goodbye to Ripple’… even leaving in my 2-glasses-of-wine snarky comment):

Most people (not all) have conceded that Ripple is not about being ‘money’, but a functional tool. In that case, we ought to value it on that metric – how much value is being created, and to where does it accrue?

Let’s use some numbers.

$207 trillion annual market size.

Assume evenly distributed, that’s about $500 billion moving a day.

There are 86,400 seconds in a day. Again, assuming smooth distribution if XRP was 100% used as transfer medium in the market, every 5 seconds (on average) it would have to move about $30 million. If we assume it needs that FULL balance to be held in 15 different currencies, that’s a required market float of 30million x 15 = $450 MILLION (that’s million with an M). Heck – let’s say that we’re off by an order or magnitude somehow and multiply by 10. Now we’re back to billions - $4.5 billion – or less than half the current capitalization.

Is there a fault in that example? I honestly don’t know. I just spent 5 minutes working it out and have had a couple of glasses of wine. My point is, talking about value being created and that same value accruing to the benefit of the actual coins is talking about two very different things. It’s the same thing as a company you might love, but whose stock is awfully priced.

While people may love-love-love XRP as a trade right now, if it is going to maintain its value, it has to be demonstrated in theory perhaps, but ultimately in practice why it needs to be valued more than, for instance the $4.5 billion in my example above. Otherwise its value is being propped up by raw speculation - not buttressed by any fundamental value. This in turn leaves it subject to significant (and perhaps inevitable) correction risk.

I didn’t really want this to be about Ripple, so I’ll just add one more thing before moving on – in the cryptomania we’re seeing today, going up in value is not proof that a fundamental valuation is sound. Maybe there are other fundamental justifications for why XRP needs to be valued where it is (outside of a speculation medium). If there is/are, I have yet to see it/them. If you genuinely see a way to correct me, then by all means, don’t waste time leaving Anonymous blog comments – send it to me and convince me. I guarantee I’ll issue an ‘eating my hat’ mea-culpa report highlighting the error(s) in my (now current) thinking. 

So – back to how value accrues to a coin in general.

If you cannot identify how value must accrue to a coin (whether as a function of facilitating a smart-contract, money transfer, or otherwise) then you are very likely veering away from investing and toward speculation.

Hey, there’s nothing wrong with gambling/speculation per se. I’ve personally never been really good at it. Some people are. But before you convince yourself that you are blessed with innate intuitive trading sense, consider this: All those glorious and impressive Las Vegas hotels and monuments were paid for by losers – and though I’ve personally known a few paper-millionaires in the dot-com boom, each of them quietly went back to their day jobs a few years later.

As the saying goes: Bulls make money. Bears make money. Pigs get slaughtered.

Good luck!

Izzy

EDIT: March 2018: if you've read up until this point, then hopefully you have enjoyed it. Considering how many hits this page gets, i thought i would mention that if you are interested in engaging me for cryptocurrency education or advisory, please feel free to email me. I've always happy to have a chat.

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[1] Technically speaking fungibility really falls under the purview of Medium of Exchange. I’m happy to leave it as a 4th criterion though given it’s incredible importance and difficulty of grasp for many, which I think may be remedied by calling extra attention to it.