Many of the investors and financial institutions I talk to are hesitant to invest in cryptocurrencies, often saying that they can’t determine their real value. For example, if we were looking to buy equity in a company, we could look at its fundamentals and make a prudent decision about whether to invest in it or not. 

Crypto is different. It is in its early days and can’t present evidence of a long track record.

Admittedly, the process of value assessment may not be as straightforward for cryptocurrencies as for some of the more traditional asset classes. However, we can still refer to certain other drivers to help us form an assessment of value.

Let’s start with the original cryptocurrency, Bitcoin, and discuss how it compares to gold and commodities.

Valuing Bitcoin – Stock to Flow Ratio

Bitcoin is often valued using the stock to flow ratio, which quantifies the “hardness” of an asset. A report by Bayerische Landesbank found that:

“Applied to Bitcoin, an unusually strong correlation emerges between the market value of this cryptocurrency and the ratio between existing stockpiles of Bitcoin (“stock”) and new supply (“flow”).”

The book “The Bitcoin Standard” by Saifedean Ammous introduced the stock-to-flow approach in relation to valuing Bitcoin. 

Bitcoin has hard-coded coin supply management.  Satoshi set into the protocol a drastic decline in supply growth (due to halving every 4 years). The Price decouples from mining efforts. When the price rises, the difficulty of mining Bitcoin increases. Subsequently, new supply, or flow, correspondingly reduces.

The existing setup guarantees the supply profile. If the supply profile would change, it would adversely affect the peer to peer network that holds bitcoin and dilute the value of their coins.

As a comparison, the stock to flow ratio is the way we value gold. Investors use gold as a store of value in hard times.  The supply of gold cannot be increased in huge quantities, and the annual production of fresh gold (“flow”) is limited, adding only incrementally to the existing stockpile (“stock”). 

So gold has a high stock to flow ratio.  However much the price of gold increases, the amount produced will not be increased exponentially, which would dilute the stock to flow ratio.

The next Bitcoin halving is due to take place in May 2020, potentially hugely increasing the stock to flow ratio of Bitcoin. It will be interesting to see what that does to the Bitcoin price.

Valuing According to Utility

A cryptocurrency must have a strong use case to incentivize people to have the coins. How useful a coin is feeds through to the value of the coin.

If we take the example of Ether (ETH). To execute commands and develop applications on the Ethereum blockchain, you need to own ETH. The Ether is converted into “Gas”, which is used to run the network. Ether is, therefore, the currency used to drive transactions and development on the Ethereum blockchain. 

The more people that are transacting with and on Ethereum, the greater the demand for Ether becomes, eventually leading to a price increase.

“Users will use the infrastructure that offers them the applications they need. And yes, at the moment this is clearly Ethereum. There are more Apps and smart contracts deployed on Ethereum than on all other application-focused blockchain protocols put together.” – Max Lautenschläger, Managing Partner, Iconic Holding

Therefore, the price of utility protocols is contingent upon community activity and the adoption of applications built on them. As long as they continue to build and adopt, the growing utility that will continue to drive value.

There are many other types of cryptocurrencies and crypto assets, as my colleague highlighted in a recent article. 

Crypto may be in its early stages and extremely volatile. However, traditional investors and financial institutions can rest easy knowing there are standard ways through which you can calculate value.

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This article is strictly for educational purposes and isn’t to be construed as financial advice.