As the digital asset investment community has grown more sophisticated over the past few years, more and more digital asset valuation methods have emerged to provide portfolio managers with mathematical models they can use to determine in which digital assets they should invest.
Here, the BMJ team explores four of the most commonly used digital asset valuation methods and how they are used by professional investors to make investment decisions.
Digital Asset Valuation Methods
Traditional company valuation models such as Discounted Cash Flow (DCF) or the Dividend Discount Model (DDM) cannot be applied to digital assets as they are an inherently different asset class than stocks. Hence, new valuation models needed to be created to provide investors with frameworks for the fundamental analysis of coins and tokens.
Four of the most popular digital asset valuation frameworks that have emerged include:
- The store of value thesis
- Token velocity
- Metcalfe’s law
- The network value to transaction (NVT) ratio
Store of Value (SoV) Thesis
The store of value thesis states that a digital asset’s value is a function of its ability to act as a store of monetary value for its investors and users. In other words, the more a digital currency or token can be used as a store of value, the more valuable it should become in the future.
Messari’s Qiao Wang believes that “value will ultimately accrue to [store of value] crypto assets.” For a digital asset to become a store of value, he states, they need to be immune to theft, have credibly low inflation, and a low cost of conversion.
As an example of calculating the fair value of the price of bitcoin with Store of Value (SoV) in mind, we could look at the price of gold and make the assumption that bitcoin could one day replace gold as the go-to store of value for investors.
At a current gold price of around $1,300 per troy ounce, the total value of the world’s gold bullion is around $8 trillion. Should bitcoin replace gold as a popular store of value globally and its total network value rise to $8 trillion, knowing that the total supply of coins is capped at 21 million, the price of one BTC would end up being $380,000.
$8 trillion / 21 million BTC = $380,000 per one bitcoin
Multicoin Capital’s co-founder Kyle Samani computes token velocity as a function of transaction volume and average network value, generally measured annually. A high token velocity would suggest that while there is a high trading volume for a token, the value of the underlying network may not increase anywhere near the same rate.
Token velocity is calculated by dividing the total transaction volume of a digital coin or token by its average network value over the course of a year.
Token Velocity = Total Transaction Volume / Average Network Value
Tokens that have a high velocity tend to have little utility in their networks. Hence, when comparing the token velocity of different digital assets – especially utility tokens – investors can recognize whether a platform’s adoption will actually lead to an increase in network value and, thus, the price of the network’s token in the long run.
This can be drawn from the Equation of Exchange (MV=PQ), where token velocity is a significant driver of token price.
M = size of the digital asset base
V = token velocity
P = price of the token
Q = quantity of the token
The lower the token velocity, the greater the token price is via an appreciation of M on the left side of the equation. This thesis states that tokens with low velocity will see higher prices than other digital assets.
Another popular valuation method used in the digital asset markets is Metcalfe’s Law, which was originally used to measure communication networks. The law states that the value of a network is proportional to the square of the number of the network’s connected users.
Metcalfe’s Law can also be applied to digital asset networks, according to research by Dr. Ken Alabi. In a paper titled “Digital blockchain networks appear to be following Metcalfe’s Law,” Alabi concluded that “[blockchain] networks [are] fairly well modeled by Metcalfe’s Law, which identifies the value of a network as proportional to the square of the number of its nodes, or end users.”
To calculate the Metcalfe’s Ratio (MET) to value a digital currency network, we use Daily Active Address (DAA) as the number of connected users of the network per day and market capitalization as network value. By dividing the market cap by Daily Active Address squared, we arrive at the Metcalfe’s Ratio.
MET Ratio = Market Cap/(Daily Active Address)²
Metcalfe’s law is an excellent method to analyze the growth of a network as a function of its daily users.
Network Value to Transactions (NVT) Ratio
The network value to transactions (NVT) ratio measures the dollar value of digital asset transaction activity relative to network value, measured by market capitalization. The NVT Ratio is the digital currency industry’s valuation equivalent to the P/E Ratio and was developed by digital asset researcher Willy Woo in 2017.
To calculate the NVT Ratio for a coin or token, you take its market capitalization and divide it by its latest 24-hour transaction volume. The outcome is the NVT Ratio, which can then be used to compare one digital asset with another. Hence, the NVT Ratio is a relative valuation method.
NVT Ratio = Market Cap/Transaction Volumes
In a Forbes article, Woo explained the theory behind the NVT Ratio. He stated that in the traditional stock markets, we have the P/E Ratio, which is used to value companies by looking at their share price in relation to company earnings. Since there are no earnings for digital currencies, though, a different metric is needed to value bitcoin and similar digital assets.
“[In bitcoin land] we have a price per token, but it’s not a company so there are no earnings to do a ratio. However since bitcoin at its essence is a payments and store of value network, we can look to the money flowing through its network as a proxy to “company earnings”. […] The value transmitted on the Bitcoin blockchain is closely tied to its network valuation. The idea that we can use the money flowing through the network as a proxy for network valuation is valid. We can express this as a ratio. I call it NVT Ratio, short for Network Value to Transactions Ratio,” Woo wrote.
Therefore, a high NVT ratio for bitcoin (or any other digital currency) would indicate a high speculative value as the price is high in relation to its network activity. While this may indicate a bubble, it may also show that investors believe that this digital asset network will grow in utility in the future.
There Is No One-Size-Fits-All Digital Asset Valuation Model
Digital assets come in all shapes and sizes. Therefore, there is no single model that can be used to value all digital currencies and tokens. Digital currencies like bitcoin, Litecoin, and Monero require different valuation methods than Ethereum’s Ether, which acts as “fuel” for the smart contract platform or Steemit’s reward tokens, for example.
Hence, it is important to be aware of what type of digital asset you are valuing and whether the methodology you are using is suitable for it.
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