Valuing a cryptocurrency is not nearly as simple as valuing a stock. A stock is a piece of a company, and you can look at what the company owns and its revenue, costs, profits, and trends to determine some sort of estimate of its worth.
For crypto, it’s far more nebulous since coin values aren’t usually connected to revenues, profits, or any of the usual fundamentals that factor into valuations. It’s more about popular opinion — otherwise known as the network effect.
In a research note this week from Goldman Sachs’s economics research team, authors Zach Pandl and Isabella Rosenberg, explored using some attributes that digital assets have to find analogs to stock fundamentals.
Previously, the authors wrote, equating it to precious metals like gold (“a store of value”) was a common framework to view assets like bitcoin. The big difference is gold doesn’t really have networks of users.
But social media does.
“Cryptocurrency prices may also be related to the value of their underlying distributed networks, in the same way that equity valuations of social media companies like Facebook are related to the value of their proprietary networks,” the authors wrote. “We therefore compare cryptocurrency valuations to various proxies for network size, similar to the way in which social media valuations are compared to network metrics such as monthly active users (MAUs).”
A way to think about crypto’s fundamentals
Using blockchain addresses to estimate the number of users on a network (say, bitcoin or dogecoin), the Goldman analysts compared this with the currencies’ market capitalization (how many coins are in circulation multiplied by the coin’s value). They did the comparison for Bitcoin, Bitcoin Cash, Dash, Ethereum, Ethereum Classic, Litecoin, XRP/Ripple, and Zcash.
“We observe a clear correlation between market capitalization and network size in cross-sectional data,” the analysts wrote.
How big the correlation is the question, however. The network effect is often seen in a relationship in which the value increases by the square of the number of nodes or participants. (So 10 nodes would give a value of 100, and 9 would give 81.) In this theory, the value correlates to the number of connections.
But for cryptocurrency assets, there’s already a real value attached — the market cap — so the Goldman analysts looked at the relationship between the number of participants and the market cap to see how it aligned with the “clear correlation” they observed across those eight crypto assets.
“Cryptocurrency market caps have generally been positively correlated with network size, and have risen more than one-for-one with network growth,” the analysts wrote. The average growth curve, they calculated from historical data, is something like value = users to the 1.4 power. This gives a benchmark ratio for what fundamentals “should” be, similar to using a historical P/E ratio as a benchmark to what a stock “should” be priced at.
Bitcoin’s market cap is far greater than its ‘fundamentals’
For bitcoin, there’s a serious deviation from the value it should have (its “fundamentals”) based on the amount of user growth compared to the value it actually has in the form of its market capitalization.
Over the past few years, the analysts said, the value of bitcoin rose 520% from its 2018 average, while its network only grew between 60% and 100% (depending on where in 2018 you count from.)
Based on its user growth, the increase in bitcoin’s value should have been lower – 90% to 150% – not 520%. Again, the idea here is this figure could represent the growth of bitcoin’s “fundamentals,” which, like with stocks, doesn’t always tell the whole story.
The difference between its fundamental value and its market capitalization means it’s either misvalued now, it was misvalued back in 2018, a combination of the two. Or there are other factors at play, like bitcoin being perceived as cool, new, an easy way to get rich quick or in some other way attractive.
Some of those factors, like sentiment, complicate things further. But how many people actually use a crypto asset is a form of sentiment – whether they’re joining the network and creating an address or buying and selling cryptocurrency.
That’s why looking at these network “fundamentals” is really only one tool in a valuation toolbox.
“Rising prices may generate more speculative trading activity and therefore address growth. For this reason, rising network activity may not represent an improvement in cryptocurrency ‘fundamentals’: the platforms do not have more economic value through network effects simply because of higher speculative trading,” Pandl and Rosenberg wrote. “For cryptocurrency networks to have sustainable value, activity will need to be driven by non-speculative use cases.”
For now, they added, those use cases just aren’t here.