How to Value Cryptoassets (Part I)
By: Iris Loh
Tags: Investment, Ethereum, Cryptocurrency, Bitcoin, Blockchain

Prophesying moons and dips with the power of valuation

This is Part I of a two part series. Check out Part II on valuing cryptoassets here!

Photo by Gianni Zanato on Unsplash

Bitcoin has gone through a lot: from being worth basically nothing (at inception), it has seen highs of USD$19,650.01; and for the past two months, have seated comfortably between USD$6,000–7,000. It is unbelievable for the early investors to see how this humble currency multiplied almost 2,000,000% in the span of 8 years. However, even without the well-publicized dip in May 2018, many are doubtful of Bitcoin’s potential. So, how does one even begin to value Bitcoin, or any cryptoassets in general?

To date, cryptoassets lack any proven valuation models, making their speculative value and volatility exceptionally unpredictable. Even Bitcoin, which enjoys more price stability than lesser-adopted altcoins due to its relatively large user base, is victim to violently soaring and crashing values. It is common knowledge that news (real or fake) could impact the trading prices of the coins.

But, so what?

Why are valuations important to you ?

Two of the most prominent reasons why you should care about valuations, whether you are a retail investor or active trader are:

1. Valuations demonstrate growth potential.

Growth potential indicates the mathematical probability of business expansion, with regards to its sales, revenue, production or workforce. This is an indicator if the business is set out to grow or shrivel. If you are a retail investor (i.e. not actively trading, maybe checking your account twice yearly), growth potential of the coin is important to you, since your focus is most likely in selecting a great project whose coin will moon over time.

2. Valuations help spot value bubbles.

Value bubbles occur when the market’s price for an asset surpasses its fundamental value greatly (i.e. paying more than what the coin is worth to obtain it). If you are an active trader, the identification of bubbles and knowing beforehand that it will eventually pop, is crucial to the trade decisions.

Hence, although there are no proven valuation models in the cryptoscene, the importance of it has gotten people to put forth their expertise and knowledge to propose such models.

We currently value BTC/ETH using NVT Ratio or NVT Signal

NVT Ratio

Traditional financial valuation means utilize the P/E ratio to determine if a company’s shares are over or undervalued, relative to its per share earnings. The problem with applying these traditional financial valuations to the cryptomarket is that there are fundamentally incompatible characteristics of cryptoassets. This makes us unable to value cryptoassets — e.g. if a cryptoasset does not have reported earnings, then one can’t use this model.

Thus, Willy Woo proposed a valuation method: the Network Value to Transactions (NVT) ratio. The NVT ratio measures the dollar value of a cryptocurrency’s market capitalization relative to the daily on-chain transaction activity.

Initial NVT Ratio

Its roots lie in quantity theory of money; where MV = PQ, in which

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

as interpreted by Chris Burniske.

Burniske explained this theory in the context of the cryptomarket very succinctly here. Put simply, the indicator of the currency’s usefulness is estimated by transaction volume. Hence, a higher NVT value roughly translates to a more expensive cryptoasset, which might be an overvalued or a high-growth asset.

A caveat that should be noted is that the daily transaction volume used in the equation only includes on-chain transactions. This includes transactions shuttling assets between exchanges and wallets (boosting NVT). Also, it does not account for trading activity happening on exchanges (resulting in a lower NVT). Thus, NVT acts as a rough estimation of its value, and may not be accurate in what it sets out to measure.

NVT ratio is touted as the index that could call out the difference between a bubble and consolidation.

Graph of Bitcoin and its NVT Ratio. Source: Woobull.com

Bitcoin’s two bubbles (highlighted in green) detected by NVT Ratio retrospectively. When NVT Ratio exceeds the ceiling of the normal NVT range (dotted lines), it signifies a bubble. If the NVT Ratio remains within the range, drops in prices (network valuation represented by the solid yellow line) is generally a consolidation instead of a bursting bubble.

However, if you look closely, the NVT Ratio ‘danger’ spikes do not precede Bitcoin’s price corrections. Cryptolab Capital astutely pointed out another flaw of NVT: NVT does not predict nor describe bubbles.

“The spike in NVT follows the bubble with a considerable lag of a few months. Peak NVT coincides with the middle of a correction period. NVT is neither predictive (doesn’t precede the overvaluation), nor descriptive (doesn’t coincide with it). You can only detect the bubble a few months after it bursts.” — Dmitry Kalichkin (emphasis, his), 2018

NVT Signal

Thus, Kalichkin tried to overcome the issue of this “considerable lag” by building upon Woo’s creation to derive the NVT Signal. It saw a revision of NVT Ratio to a 90-day moving average (as in the formula below). NVT Signal is arguably known as the P/E ratio of Bitcoin, where earnings are proxied in form of network size.

Kalichkin’s NVT Signal

For details on why Cryptolab chose a 90-day moving average, read Kalichkin’s explanation.

Graph of NVT Signal (dark green dotted line) and BTC price (red solid line). Source: Dmitry Kalichkin’s calculations

As seen on Kalichkin’s chart, whenever NVT Signal (dark green dotted line) crosses into the yellow or red zone (after July 2013, July 2014, and December 2017), BTC witnessed price correction (i.e. dip in prices). Also note that the peaks in NVT Signal into the ‘danger’ red and yellow zones preceded or coincided with the falls in BTC prices. In this, the NVT Signal shows improvement from the classic NVT Ratio by predicting or describing price consolidations.

Even Woo recognised the usage of NVT Signal:

“(NVT Signal is) responsive enough to use as a trading indicator.” - Willy Woo, 2017

NVT Signal, despite its successes, still was unable to correct for a major flaw: it does not account for off-chain transactions (as mentioned before as a weakness in NVT Ratio).

Also, NVT Signal might not be this accurate in predictions for all coins, since only 2 factors are included in the metric (i.e. network value and on-chain transaction volume). It is also likely that its use is limited to large cap coins, since small cap coins do not have the network value or history, yet, to be analysed in this manner. Also, if there are projects that utilize blockchain technology in the backend of their service provision, we might need a totally different valuation technique to accurately assess it.

“At its essence, Bitcoin’s NVT ratio is a comparison of how much the network is being valued to how much the network is being used. If you’re applying the NVT ratio to a different network, the value transmitted on-chain needs to be a good representation of how much the network is being used. This is not always the case.” Willy Woo, 2017

Together, these metrics can be coupled with an assessment of the cryptocurrency’s ownership base characteristics to further analyze and compare the value of certain coins.

Photo by Kendall Ruth on Unsplash

On Creating your Own Multiples

Why not give it a shot? Understand the trends and data available, and break down factors you believe that make up fundamentals of cryptocurrency. Next, find proxies to indicate quantitative measures in the selected fundamentals. This may come in the form of twitter hashtag uses on social media buzz.

Alternatively, you could choose to review existing indicators (like P/E ratio) and translate it to fit the cryptoclimate, or overcome limitations faced by existing multiples.

In this relatively new industry, it is anyone’s game to come up with a useful ratio. Don’t be afraid to be wrong, just work the mistakes into insights. For, as Warren Buffet’s timeless advice goes,

“It is better to be approximately right than precisely wrong”.

Check out Part II on Price-to-Metcalfe’s Ratio as a cryptoasset valuation model!