Before stock investors buy any company’s shares, they consider several things to make sure they will get a return on their investment. Everything investors do is intended to answer one question? How valuable is the stock? To measure a company’s stock value, investors and analysts do fundamental analysis for that stock.
However, it is not quite the case with digital assets. Valuing a cryptocurrency asset like bitcoin, dogecoin, and Ethereum, among others, is not nearly as easy as valuing a stock. This is because of the clear difference between these two assets. A stock is a piece of a company, and you can estimate its value by looking at things like its revenue, costs, profits, and assets following its quarterly reports. This is not the case with cryptocurrencies because coin values are not usually connected to revenues, profits, or any other factors used in the fundamental analysis of an asset. A cryptocurrency’s value is based primarily on popular opinion—this is known as the network effect.
So the question remains, how do you measure the value of a crypto asset? What fundamentals should one factor in to gauge how valuable a coin is? To answer this question, authors Zach Pandl and Isabella Rosenberg from the investment bank, Goldman Sachs’ economic research team, issued a research note early this week that explored attributes that cryptocurrencies have, which can be applied to find analogies to stock fundamentals.
In the recent past, Pandl and Rosenberg have written that precious metals like gold which are perceived as a store of value, were a common framework to view assets like bitcoin, but gold doesn’t have a network of users. However, social media does, and metrics like Monthly Active Users (MAU) are used to measure how valuable social media companies like Facebook are.
In their research note, Pandl and Rosenberg wrote that the price of cryptocurrencies might also be related to the value of their underlying distributed networks in relation to equity valuations of social media companies like Facebook Inc. (ticker: FB) and Twitter Inc. (ticker: TWTR) among others. The value of social media companies is subject to the value of their proprietary networks.
After this declaration, Pandl and Rosenberg said that they compare the valuation of digital assets to various representations for network size, the same way social media valuations are compared to network metrics such as MAUs.
How to find out about cryptocurrency’s fundamentals
Although bitcoin wallet addresses don’t reveal any identifiable details, bitcoin transactions and their addresses are recorded on a public blockchain for everyone to see. So, using blockchain addresses to estimate the number of users on a cryptocurrency network like bitcoin or Ethereum, Pandl and Rosenberg, compared this (number of users) with the currencies’ market capitalization. A cryptocurrency market capitalization is a product of the coins that are in circulation and the coin’s value.
Goldman Sachs’ researchers compared Bitcoin, Dash, Bitcoin Cash, Litecoin, Ethereum, Ethereum Classic, Zcash, and XRP/Ripple. The comparisons revealed “a clear correlation between market capitalization and network size” in the cross-sectional data of these coins.
However, the question is: how significant is the correlation between a digital asset’s market cap and its network size?
How to calculate the network effect of a cryptocurrency
The network effect of a coin is seen in a relationship in which its value increases by the square of the number of computers that run that coins’ implementation and stores the entire blockchain – technically called nodes. This means that in the case of bitcoin, which is the largest cryptocurrency globally, 10 bitcoin nodes would give a value of 100 bitcoin, 9 would give 81, 100 would give 10,000, and so on. Therefore theoretically, the value of the coin correlates to the number of connections.
However, it is a known fact that there is already a real value attached to cryptocurrency assets known as the market cap. In this case, Pandl and Rosenberg went further in their analysis of the fundamentals of cryptocurrency valuation and studied the relationship between the number of participants and the market cap to see how it aligned with the correlation they observed across those eight crypto assets.
The authors wrote that cryptocurrency market caps have generally been positively correlated with network size. They also noted that these two metrics had risen more than one-for-one with network growth over time.
According to calculations from historical data, the two researchers found that the average growth curve is value = users1.4. This simple formula gives a benchmark ratio for what cryptocurrency fundamentals should be, similar to how the historical Price to Earnings (P/E) ratio acts as a benchmark to what a stock price should be.
Bitcoin’s market capitalization is far greater than its fundamentals
The two Goldman Sachs researchers noted that there’s a serious deviation from the value bitcoin should have based on its user growth compared to the value it actually has in the form of its current $590.45 billion market capitalization.
According to crypto analysts, bitcoin’s value has grown by 520% from its 2018 average, which is far higher than the rate of its network growth in the same period, which was between 60% and 100%.
If we are to go with the rate of bitcoin’s user growth, its value should have grown between 90% and 150%, depending on when you start counting in 2018, and not 520% that it has reportedly grown. Like stock fundamentals that don’t tell the whole story about a stock’s performance or growth, this increase in bitcoin value does not necessarily represent the cryptocurrency’s fundamentals.
The difference between bitcoin’s fundamental value and its market cap brings us to three possibilities: Bitcoin might currently be valued incorrectly; this likely happened in 2018. Alternatively, it could also be a combination of the two where its value was incorrect both in 2018 and at present. Another factor that could explain this significant difference is how cryptocurrency enthusiasts see bitcoin as a fantastic, new and easy way to get rich quick. According to Pandl and Rosenberg, sentiments like these complicate things even further. They are why looking at these network fundamentals is not conclusive but just one of the ways to value cryptocurrency amongst other alternatives.
Pandl and Rosenberg added that rising cryptocurrency prices might generate more trading activity from investors speculating a continued increase, which in turn might lead to network growth.
For this reason, the two researchers from Goldman Sachs added that rising network activity might not necessarily represent an improvement in cryptocurrency ‘fundamentals.’ The platforms do not have increased economic value through network effects because the increase in trading activity is simply speculative.
They concluded that for cryptocurrency networks to have sustainable value, activity needs to be driven by non-speculative use cases.