3 Key Concepts in Valuing Cryptocurrencies

I can’t stress enough – cryptocurrencies are assets that should be considered very risky. If you are not comfortable with losing your entire investment, you should likely look for other investments. This article assumes an understanding of stock valuation fundamentals and the blockchain.

Since my first article, Going from Stocks to Bitcoin, My First Purchase, I’ve encountered the two following questions repeatedly:

a) How did I research which coins to buy
b) Where do I purchase the coins

In this post, I will answer the first question and outline my methodology for examining different coins and list a few of my favorites. Understand though, this is one of many ways people think about valuing cryptocurrency. This is meant to be a walk through my particular thought process and not a guide to exactly what you should do when looking to buy a coin. You should do your own research before investing in any cryptocurrency.

Researching Cryptocurrencies

For starters, I will say there is hardly a source similar to stock research reports for how are cryptocurrencies valued. Instead, what you primarily find are people who are interested in the currency with their own opinions about why currency A is better than currency B. Much of their analysis is typically based on a) the technical nuts and bolts of the currency or b) the application of the currency in the actual economy.

This makes doing your own research critical to making good investments in cryptocurrency. The lack of expert opinions means you need to understand the market and make informed decisions about which coins are worth purchasing.

My process for research consists of three inputs: overall market size opportunity; supply and demand; and potential adoption.

1) Understanding the Cryptocurrency Market Opportunity

The first thing I do is go to the website for the specific coin I’m analyzing. This is the starting point for understanding how cryptocurrencies are valued. This first step gives me a good sense of what purpose the coin will serve. With this step, I’m able to get a sense of what the coin is trying to do on the blockchain, it’s staff of people, and its roadmap for development a.k.a. what they are building next. They will also have a “white paper,” which outlines why the coin is in existence and the applications of the coin. These may also be called “use cases,” which are cases where the coin can be used. These basics help me understand the basics of a specific crypto-coin.

Ripple has a good example of use cases for their coin and why the creators believe it will be viable in the long term. They are focused on improving transfers of money between countries. Currently, and outdated process with room for improvement and trillions of dollars in size. An example white paper for Ripple’s coin (XRP) is available online.

What I look for in this first step are big and addressable markets. For example, Ripple wants to create a better payment infrastructure for global institutions that is faster and more secure than what exists now. Trillions of dollars are at stake in this market, and as more consumers are connected to mobile devices and the internet, especially in the developing world, there is a lot of potential. Additionally, Ripple’s main “customer” are businesses, which I prefer as an investor. Businesses are less fickle than consumers and many financial institutions are in need of better global payment solutions.

There are plenty of coins that talk about market opportunities, but their addressable market isn’t big enough or the potential return is small. I look for big addressable opportunities as the first key input.

2) Cryptocurrency Supply and Demand

Generally, with a stock investment, you can assign value through a variety of methods. The primary basis is the sum of future cash flows from the stock, discounted back to the present. For example, think of a business like General Electric, that makes a variety of items for business and consumer use. Stock analysts can reasonably estimate sales, margins, and cash flows and apply an assumed discount rate to get the stock value. Since cryptocurrencies don’t actually have cash flows that are being generated, this is a little more challenging.

The second input I look at is supply and demand of the currency. Why? Because the basics of microeconomics will tell you that, in general, limited supply and high demand will lead to higher prices and lots of supply with low demand will lead to lower prices. This isn’t a hard and fast rule, but one that I use personally. The place that I go to analyze these dynamics is Coinmarketcap. Below is a screenshot of the website.

You’ll see in the fifth column, the “circulating supply” section shows how many coins are available to purchase. Bitcoin has 16.7 million available, while Ripple has 38.7 BILLION. You can see the price of Bitcoin is at $19,407 while Ripple is under $1 ($0.75). Based on the dynamics of supply and demand, it’s highly unlikely that Ripple will get to a price like Bitcoin. However, Ripple has, in the past month, quadrupled in price so there are opportunities in lower-priced currencies to have good returns.

Now, you may say “I want to buy more Ripple because it costs less.” Paying $500 for 1 coin is the same as paying $0.50 for 1000 coins, so that logic isn’t correct. There is no difference in value in either scenario given you will come to the same amount invested of $500.

Most people are turned off by a higher price – the good thing about crypto is that you can buy 1 or .01 or .00001. You may be able to get more price appreciation from a coin that is higher priced. For example, One BTC (Bitcoin) was worth ~$1,000 at the beginning of the year and now is over $19,000. One Ripple (XRP) was around $0.25, and now it is at $0.75. It is a lower price than BTC, but with Bitcoin, your return was 18x vs. 4x for Ripple. However, if you believe that there is the potential upside for a lower priced coin to outperform, then, by all means, you should look into that coin.

3) Will My Coin Get Adopted?

This is a hard question and the most up in the air.

I will say first that I have no idea whether any of these coins will have mass adoption in the near or even immediate future. I believe that a lot of the price appreciation has been a function of excitement about the possibility of adoption, but no one really knows.

However, this is the third input I “try” and look at. The keyword is “try” because no one can actually predict most things accurately. So, I look at things including the first input of market size, who the coins’ customers are, and what are the barriers to adopting a coin. Take Bitcoin for example. It’s mainly used as a form of payment now for goods and services. It’s just starting to get included online for payment options, and I haven’t found a good way to understand how many people are using it.

Additionally, Bitcoin is really volatile. There is a story about a person who purchased two pizzas in 2010 for 10,000 Bitcoin. That today would be worth $100 million – I would be pretty pissed if my method of buying stuff was that volatile and i literally gave someone $100 million 7 years ago. Then there is a trust issue – will people actually trust a “decentralized” system to process payments? I don’t know (people were skeptical when the US Dollar went off the gold standard, too).

So, long story short, I try to think about the adoption of certain coins. It’s a total guess and I will admit that. I have more faith in some vs. others, but I admit I could be completely wrong about them. Make an educated guess based on what you can learn about the competition and market landscape.

Tying The Three Concepts Together

This is my own framework for thinking about coins. This is by no means investment advice, but it is how I have gotten comfortable with buying coins. I’ve used this framework to evaluate several different coins. From that research, I have built out a portfolio of seven (7) different coins I think have potential.

1. Ethereum – big market for contracts and business users
2. Litecoin – faster transaction speed and scalability compared to Bitcoin
3. OmiseGo – banking the unbanked in developing countries
4. Wagerr – Peer to Peer (P2P) betting. Global gambling market is $635B by 2022
5. Bitcoin Cash – more scalable and better transaction speeds vs. Bitcoin
6. Singular DTV – entertainment studio on blockchain for artists to distribute content without a middleman. Global entertainment industry was $1.7 trillion dollars in 2015
7. Music Coin – music distribution for artists with direct payment.

I won’t go into detail about each. As an example, I did look at a coin called Status (SNT), that I considered and decided against investing in. They have good dynamics in my opinion, with 6.8 billion total coin supply and a large addressable market. Essentially, they are creating an app-based platform where people can do everything from browse, chat, and send or store coin on blockchain – think a WeChat for cryptocurrency.

They had a really popular ICO and a lot of press, but I ultimately decided against Status because of the adoption. I believe it will be difficult to get mass adoption of their platform to warrant a big jump in price. Thus, I don’t own any SNT.

But I could be totally wrong. I am a firm believer that doing your own research and making the ultimate decision on your own is an important step in the process of expanding your cryptocurrency portfolio. There are literally thousands of coins out there – many of which will go bust and some that will do well (hopefully). You can find a comprehensive list of coins at Coinmarketcap.

If you are just starting out and looking for an easy way to start buying, try Coinbase. They are well known, secure, and actually insure your money from being hacked. Click here to get $10 in free Bitcoin by signing up.

Good luck in your quest! It has been a fun and challenging experience for me to learn and research about coins, so happy hunting! Leave a comment with any coins you like or questions on investing.