Your Guide to Valuation of Crypto Assets

Valuation of Crypto Assets - Introduction

The world of crypto assets, with Bitcoin as its leader, is exploding both in terms of volumes and market capitalization. It’s also giving rise to numerous innovations with promising technology, gaining expertise in several industries. The new crypto initiatives are different and distinctive from what we are familiar with in nature, yet they appear familiar. We have become used to market/trade exchange, venture capitalism, crowdfunding, and other aspects of our everyday life that the markets for cryptocurrency have also absorbed.

We are noticing countless crypto projects looking for funding through the initial coin offering (hereinafter ICO), which essentially resembles an initial public offering (hereinafter IPO). Likewise, compared to an IPO, crypto projects issue coins or tokens, which can represent part ownership. However, they can also be used as currency to buy services and products, they can be utilized as a means of transaction or store of value, and they can even have no goal whatsoever. This leads to a comprehensive new area of business models for crypto projects. Since tokens are bought and sold publicly on crypto exchanges, they can be used by anyone for investment purposes, speculation, or just as a means for something that the token is intended for. Tokens represent the blockchain-derived equivalent of “value” in the crypto world and can take many different functional values. Therefore, the collective uses and values of tokens are categorized as crypto assets. In this blog, we demonstrate and discuss the various methodologies for the valuation of crypto assets.

Differences in Crypto Asset

Nick Tomaino, the founder of cryptocurrency-focused fund 1confirmation (2017), focused on what the underlying value of crypto assets is. He recognized four major token types that offer different types of fundamental value. If a token does not fit clearly into one of these categories, he believes that it will be hard for it to maintain any long-term value. The four token types are:

1. Traditional Asset Token

A token type that cryptographically represents underlying traditional assets such as gold, equity, real estate, etc.

2. Usage Token

A token type where the token is required to access or use the digital service offered by the project. Its fundamental value is determined by the uniqueness of the resources underlying the digital service and the utility of the service itself. Examples: Golem, 0x, Civic, Raiden, Basic Attention Token, etc.

3. Work Token

A token type that gives token holders the right to contribute work to the project. It can help enable the Decentralized Autonomous Organization (DAO) to function. Its fundamental value is determined by the utility that token holders get from the decentralized organization. The utility can come in the form of fees or goodwill. Examples: Augur, Keep, Truebit, Gems, etc.

4. Hybrid Token

Many future tokens may function as both usage and work tokens. Example: Ethereum when it will switch from proof of work to proof of stake. That way it will be both a usage token (for network usage) and a work token (for the right to validate transactions and be paid for that).

Crypto Valuation Approach and Methodology

There is an arising body of industry perceptions and economic exploration associated with crypto valuations, with a major portion of the exploration focused on valuing Bitcoin or Ether. Most of these perspectives and research come from academics, though some of the explorations also come from the financial services community, and even less common, a scattering of the perception comes from a small group of blockchain sub-culturalists. Based on our research and experience, we find three approaches optimal for valuing crypto assets:

Approches to Valuing Crypto Asset

Cost of Production

Value as a Currency

Value as a Network

Cost of Production Approach

Adam Hayes, a graduate student at The New School for Social Research, has published several empirical publications on the valuation of crypto assets. According to his research findings, three factors, namely Computational Power, Coin Production Rate, and Relative Complexity of the Mining Algorithm, can influence almost 84% of the value of cryptocurrency assets. According to Hayes’ hypothesis, the marginal cost of mining Bitcoin should be equal to its price. The marginal cost refers to the cost of producing one extra unit of Bitcoin. This hypothesis suggests that there is a direct relationship between the cost of mining and the market price of Bitcoin. However, it is important to note that this is just a hypothesis and may not always hold true in practice. Various factors such as technological advancements, energy costs, and market demand can impact the actual cost of mining Bitcoin.

Hayes suggests that Bitcoin has intrinsic value. While Bitcoin is intangible, it has similar attributes to traditional commodities, such as labor value. According to Hayes, it is perhaps more appropriate to think of Bitcoin as a virtual commodity with a competitive market against producers rather than approaching it as digital money or currency.

According to Hayes, the adoption of crypto assets increases with the amount of mining power used. A crypto asset that is not used or accepted won’t receive any value or processing power. Any opportunities for excess returns are short-lived as the competition drives down profit. This is based on two forces:

  1. Miners seek and mine for the most profitable coin which raises the aggregate network hashing power in that coin, causing the difficulty to increase.
  2. As the difficulty increases, profitability falls per unit of mining effort and the market exchange rate will change as mining participants actively produce and subsequently sell relatively overpriced coins.

The variables in Hayes’ formula are:

  • The cost of electricity, measured in cents per Kilowatt-Hour.
  • The energy consumption per unit of mining effort, measured in Watt per giga hashes per second.
  • The monetary price of Bitcoin in the market; and the difficulty of the Bitcoin algorithm. Using established microeconomic theory, the marginal product of mining should theoretically equal its marginal cost in competitive markets, which should also equal the selling price.

Therefore, Hayes proposes the following formula,

$P = Eday/ BTC / day 

$P is expressed in dollars per Bitcoin
Eday is the cost of mining per unit of mining power per day
BTC/day is the expected number of coins to be mined per day on average per unit of mining power.

Value as a Currency Approach

Co-author Chris Burniske suggests pricing crypto assets using Irving Fisher’s Equation of Exchange method in Crypto Assets: The Innovative Investor’s Guide to Bitcoin and Beyond. This formula was initially created to forecast currency values based on the popularity and efficiency of macroeconomic transactions. The equation of exchange is often written as MV = PQ, however Burniske claims that calculating M is a key component in valuing crypto assets, hence the formula is modified to read as follows:

M=PQ/V

M = size of the monetary base necessary to support a crypto economy of size PQ, at Velocity V
V = velocity of the asset
P = price of the digital resource being provisioned
Q = quantity of the digital resource being provisioned

Burniske, in his model, conducts a total addressable market (TAM) analysis, used typically in traditional finance for analyzing start-up companies. To value Bitcoin, Burniske emphasizes the importance of determining the size of the addressable market, the market share that Bitcoin will take, its velocity, and the appropriate discount rate.

Value as a Network Approach

The third method for valuing crypto assets employs the concept suggested by Ethernet’s creator, Robert Metcalfe. Metcalfe pointed out that the value of a network is proportional to the square of the number of nodes in the network or the number of users. As per studies, the relationship may be accurate when applied to significant social networks. Metcalfe attempted to validate his conclusions using Facebook as a proxy in a 2013 article. As per the hypothesis, a network has little or no value with just a few users, but with each new user, the network’s utility value more than doubles.

Ken Alabi, Ph.D., claims in his study that Digital Blockchain networks appear to be following Metcalfe’s law and that the value of Bitcoin can be calculated using Metcalfe’s Law. Alabi employs three distinct Crypto.

As examples, consider Bitcoin, Ethereum, and Dash. Alabi proposed using the number of unique addresses participating in the network daily as a proxy for the network’s relative number of active users. Alabi proposed a Metcalfe’s Law variant based on the exponent of the root of the number of active users. Using historical crypto asset data, Alabi demonstrates that historical market values do indeed follow the model.

The formula for figuring out the value of Bitcoin is as follows.

Value of Bitcoin = Unique Addresses2 * $ volume per account

Unique Addresses represent the number of unique Bitcoin addresses participating on the network per day
$ Volume per account represents Bitcoin transaction volume per day.

ValAdvisor Expertise

As per the above-mentioned factors, we understand how to determine the fair value of cryptocurrency by using different methodologies/ approaches. Crypto enterprises may more effectively bargain to acquire or sell shares and raise cash at various stages by having a good understanding of these crypto asset valuation processes.

At ValAdvisor, our dedicated team of experts specializes in determining the value of a business or assets, for transactional, accounting, taxation, regulatory, financing, distressed asset resolution, litigation, insurance, strategic, planning, and operational purposes. Our expertise in various advanced models and simulation techniques helps us in delivering reliable and accurate valuations. Count on us to provide tailored solutions that empower you to make informed decisions with confidence.

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