Investments in cryptocurrency: Valuation

The first part of this series: Investing 101: 5 basic tips for beginners in cryptocurrency, was appreciated by the community, be sure to check it out if you want to review the fundamentals.

Important Disclaimer: I am not a financial advisor or expert and not responsible for any losses you make or gains you don’t make because of this article. Your choices are your own.

In this part, we are going to delve deeper into the valuation of a cryptocurrency. It’s hard to put cryptocurrency in an asset class. There is a wide range of crypto’s out there and they differ significantly.

The source of value

You could argue that cryptocurrency behaves as a currency (what’s in a name, right?). There is a big difference in the fundamentals. If you look at the main source of a standard cryptocurrency, you’ll find out there is scarcity involved. Most cryptocurrencies have a max mineable/producible amount of tokens they can mine. If you compare this to normal currency there is a big difference, since money can be printed when necessary.

A commodity like gold would be a better fit in this case since there is scarcity but it’s still able to facilitate a transaction and there are production costs. But does gold produce anything in rest, does it have an output besides supply and demand?

If you would say that cryptocurrency behaves like a stock, it is more of an entity with utility than just a facilitator of a transaction. Sure there are tokens out there which actually produce something. STEEM produces great content all day long. The tokens can be traded, but facilitating transactions isn’t the main goal. The main goal is to produce awesome content.

This puts cryptocurrency in a strange spot, because it can have similar traits as other classes and for crypto it overlaps.

Valuation of an investment

“The price is what you pay. Value is what you get.”
Warren Buffet

In order to determine if something is a sound investment you identify if the price that you have to pay makes up for the value that you get in return. So how do you know if the value of a cryptocurrency justifies the price? For stocks, the following formula plays a central role in the valuation of the price.

P0 = EPS/r + PVGO

With: P0 = price, EPS = earnings per share, r = discount rate, PVGO = Present Value of Growth Opportunities.

If you just got scared of this formula, don’t worry, it’s will only be used as an example. Basically what this means is that the price of a stock is based on two components: intrinsic value and expected growth.

This is something we can intuitively use for the types of cryptocurrency which produce value. This key point can also be used for cryptocurrency without a clear production of value such as our big brother BTC. In this case, you’ll have to see it as a combination of current supply/demand with future expectations.
It thus gives us a good reference point in knowing whether something is traded on intrinsic (underlying) value or if it’s based on expectations.

So how can you actually use this?

It’s very important to know where the value comes from before you invest. Is the main part provided by current performance or is it based on expectations?

Let’s give some examples:

The intrinsic value of STEEM would be the increasing number of active users. While the growth opportunities would be expectations about a steady increase of users by viva voce marketing.

The intrinsic value of an ICO, e.g. EOS would be
the team which has a lot of experience while the value of expectations would be the number of apps build on EOS.

The intrinsic value of BTC would be the supply/demand as well as being one of the few coins with an enormous amount of trading pairs. The value of expectations would be the average weighted expected value of the results of the UASF on 1 August.

Expectations cost money

If a lot of people expect that the growth opportunities of an investment are very high, you pay for them.
If Someone tells you “ Buy X now, because the growth opportunities are GREAT” This sounds great, doesn’t work that way.

Why doesn’t a general consensus on growth opportunities mean that it's a great deal to buy this crypto?

Either the general view is WRONG and you lose money on the investment because expectations weren't met.

The general view is RIGHT, BUT the growth opportunities were expected and thus you paid for them when you bought them.

This means that if the value of an investment is largely based on expectations (it is hyped).

you automatically pay more
there is no/little intrinsic value to back it up if things aren’t as expected.

This is exactly what makes investing ICO a great way to lose all your money or generate tremendous returns. If a lot of value is based on expectations, the investment is seen as risky. The risk/reward theory tells us that if things get riskier, the potential upside/downside gets higher/lower.

How do I not pay for the expected value?

In order to not pay for the expected value, you can invest in something where you expect a lot of value, but the general public hasn’t seen it yet.

Expectations change over time

Expectations change over time, thus the value of these expectations also change. This can happen in two ways, since expectations are subjective:

More/less people expect the same expectation
Because of an event, people expect more/less

Just because more people expect something (they heard something from a friend), doesn’t mean that the expectation is justified and this is how bubbles are made.

People with no knowledge start to act as a herd and if things go slightly south-ways, they will panic.

Why do they panic?

They based their valuation purely on other people's expectations and have no knowledge of the intrinsic value. In their mind, they see their investment completely disappearing, because expectations weren’t met in the short term and there is no underlying value.

Conclusion

Be aware that your valuation is based on intrinsic value and expectations.
Be aware of the effect of other people’s expectations.