Comparing Cryptocurrencies Using Valuation Models

Cryptocurrencies have grown from niche technological experiments to a significant financial asset class, captivating investors, technologists, and regulators alike. However, with thousands of coins in existence, valuing them remains a challenge. 

This article dives into how different valuation models apply to cryptocurrencies, their effectiveness, and real-world examples.

The Challenges of Valuing Cryptocurrencies

Unlike traditional assets such as stocks or real estate, cryptocurrencies lack universally accepted valuation benchmarks. They don't generate cash flows, dividends, or rental income.

Instead, their value hinges on:

• Market perception and adoption: some cryptocurrencies suffer from low liquidity, making it difficult to buy or sell large amounts without affecting the market price. Additionally, trading costs can be high, further complicating valuation.
• Technological innovation: each new cryptocurrency requires deep technical knowledge, which can be a barrier to traditional valuation models, while also making it difficult to establish consistent valuation methods.
• Scarcity and supply dynamics: cryptocurrencies are qualitatively diverse and not interchangeable, which complicates the valuation process. Each cryptocurrency may have different underlying technology, use cases, and market dynamics.
• Regulatory developments: the evolving regulatory landscape creates uncertainty, as new laws and regulations can significantly impact the value of cryptocurrencies.

Volatility adds another layer of complexity. For instance, Bitcoin has experienced swings from $68,000 in late 2021 to under $20,000 in 2022 before rebounding.

These challenges highlight the complexities involved in accurately valuing cryptocurrencies and underscore the need for robust valuation frameworks and methodologies.

Valuation Models for Cryptocurrencies

1. Market Capitalization
 

Market cap is a straightforward metric: Price per coin × Circulating supply. It provides a snapshot of a cryptocurrency’s relative size and impact. For example:

Bitcoin, with its capped supply of 21 million, commands the largest market cap, often perceived as "digital gold."
Ethereum follows closely, driven by its utility for smart contracts and decentralized apps (dApps).

Limitations: Market cap doesn't consider liquidity, adoption rates, or utility. A high market cap might not translate to sustainable value.

2. Network Value to Transactions (NVT) Ratio

Dubbed the "crypto P/E ratio," NVT compares market cap to transaction volume. A lower NVT suggests high network activity relative to valuation, indicating utility.

Bitcoin: consistently demonstrates a balanced NVT ratio, highlighting its dual function as both a store of value and a medium for transactions.
Ethereum: Higher transaction volume due to DeFi and NFT applications often keeps its NVT attractive.

Limitations: This model struggles with speculative assets where trading volume dominates legitimate transactions.

3. Stock-to-Flow Model

This approach assesses scarcity by analyzing the ratio of the current supply (stock) to the rate of new production (flow). Bitcoin’s halving cycles align with price surges, supporting its "digital gold" narrative.

Example: In 2024, Bitcoin’s supply inflation rate is nearing zero due to its fixed issuance schedule, reinforcing its store-of-value perception.

Criticism: It assumes constant demand, ignoring factors like regulatory risks or technological competition.
 

Source: Bitbo

4. Discounted Cash Flow (DCF) Adjustments

Though cryptocurrencies lack direct cash flows, some models adopt DCF principles. Stablecoins like Tether (USDT) and decentralized finance (DeFi) tokens like Aave generate revenue through fees, enabling modified DCF calculations.

Example: Ethereum’s move to a proof-of-stake (PoS) system in Ethereum 2.0 introduced staking rewards, resembling dividend-like returns.

5. The Black-Scholes Model

The Black-Scholes Model calculates the theoretical price of an option based on factors such as the underlying asset's current price, volatility, time to expiration, and risk-free interest rate. While it was not originally designed for cryptocurrencies, it was adapted to model the fair value of crypto assets or related derivatives. For example, the model can estimate the value of Bitcoin options traded on exchanges, providing traders with insight into pricing strategies.

However, applying the Black-Scholes Model to cryptocurrencies comes with challenges. The assumption of continuous trading and predictable volatility, fundamental to the Black-Scholes Model, often doesn’t align with the realities of crypto markets.

6. Discount for Lack of Marketability (DLOM)

The Discount for Lack of Marketability (DLOM) is a valuation adjustment applied to assets that cannot be easily sold or traded in an open market. Originally developed for illiquid securities, this concept has found relevance in the context of cryptocurrencies, especially those with lower trading volumes or restricted liquidity.

Cryptocurrencies, while often considered highly liquid, vary significantly in marketability. Major cryptocurrencies like Bitcoin and Ethereum benefit from deep markets and high trading volumes. However, smaller or emerging cryptocurrencies may face limited liquidity due to low demand, restricted access on exchanges, or regulatory constraints. In these cases, applying a DLOM helps account for the risks and costs associated with converting these assets into cash.

The DLOM is calculated based on factors like: 

• trading restrictions
• historical price data
• expected time to liquidation

For cryptocurrencies, it can reflect challenges like exchange delistings, regulatory restrictions, or thin order books that create high price slippage during large trades. These factors make certain tokens less marketable compared to widely adopted cryptocurrencies.

Practical Examples of Cryptocurrency Valuation

Bitcoin (BTC)

As the first and most prominent cryptocurrency, Bitcoin epitomizes digital scarcity. Its valuation stems from:

• Fixed supply: only 21 million BTC will ever exist.
• Market adoption: its recognition as "digital gold" has attracted institutional investment.
• Energy use debate: its proof-of-work mechanism, while criticized for environmental impact, underscores its network security.

Ethereum (ETH)

Ethereum stands apart due to its utility beyond payments:

• Smart contracts and dApps: Ethereum underpins DeFi, enabling decentralized exchanges, lending, and NFTs.
• Transition to PoS: Ethereum 2.0 improves energy efficiency and scalability, enhancing its long-term value.

Emerging Cryptos

Solana (SOL)
Known for speed and low transaction fees, Solana’s valuation thrives on scalability. Its ability to process 65,000 transactions per second makes it appealing to decentralized apps and gaming platforms.

Cardano (ADA)
Focused on sustainability, Cardano combines rigorous peer-reviewed research with eco-friendly staking mechanisms. Its valuation benefits from a strong community and transparent development processes.

Stablecoins (e.g., USDT, USDC)
Stablecoins derive value from their peg to fiat currencies. Tether (USDT) dominates the market, providing liquidity and acting as a bridge in volatile markets. However, controversies around reserve backing impact trust.

Conclusion

Cryptocurrency valuation remains an evolving field, shaped by technology, adoption, and global regulations. Investors should use a mix of models to assess intrinsic value, combining metrics like NVT with real-world factors such as technological innovation and community support.

As the crypto landscape diversifies, balancing pioneers like Bitcoin with new entrants like Solana or Cardano offers exciting yet risky opportunities. Whether you're a cautious investor or an adventurous speculator, understanding valuation is a valuable skill in the ever-changing crypto market.