How are fiat currencies valued?
Let’s first look at how fiat currency is valued. Things were really simple in the past. If people thought something was good enough, it became valuable. That’s how gold found its first valuation. After that, the future prices would be a factor of pure market play. Currencies also derive their valuation from market forces. However, some countries like Japan have fixed exchanges which means that the central banks determine a range from which their currency should operate. For fixed economies like Japan, the government determines the official exchange rate based on a major currency or a basket of a couple of currencies. Floating economies are moved but the supply and demand of a country’s currency in the international market, once in a while governments may intervene even in floating economies. Cryptos are 100% decentralized so prices are naturally set by market forces.
Characteristics of a good currency
Money has some distinct characteristics that give it value. Let’s unwrap them.
People recognize and accept money as money all over the world. You can travel with a dollar to Asia and it will be accepted as a means of exchange. You can still take it to Africa and it will perform the same purpose.
All money is the same. One unit of a 100-dollar bill is the same as all the other $100 bills across the world. This means it can be used as a proper standard of value measurement since it remains identical. Compare that to batter trade where one item, let’s say a horse wouldn’t be exactly like the other.
Money is durable. It doesn’t perish after five days like roses. So you can store it and use it in the future.
Money is divisible. Unlike cows and horses, money can be broken down into smaller units without destroying its value.
All the characteristics of money are important, but stability is one of the strongest features that drive the demand for money. People either spend or save money. You don’t want to get out of the house when the price of food is $5 and get to the market when it is $9. The stability function of money enables it to be a proper means of current and deferred payment, as well as to store value.
What determines the value of Crypto?
The usage of crypto and fiat is similar in many ways. Both are a medium of exchange and a store of value. Hence they must derive their importance from society’s acceptance and usage. That leads us to the law of demand and supply which states that “All factors being constant, increased demand will stimulate a rise in prices, and increased supply will lead to a decline in price.” Cryptos are found by mining, and it gets tougher over time. The speed at which miners can access a unit of BTC on the other hand reduces as the difficulty level increases. Some top crypto coins, such as Bitcoin, have a fixed supply. As mining gets harder, the rate of supply falls. If there is more demand for such a coin, its price will definitely shoot up. Factors such as government crackdowns that were witnessed in China last year caused a scare among investors. Most of them started panic selling their cryptos, creating an excess supply that saw the price of many coins such as BTC fall.
Cost of production
Cryptocurrency isn’t free. Miners invest resources in setting up the right computing power to verify blocks on the blockchain. Mining is a high energy consumption activity and also requires high-performance computers. For limited coins such as Bitcoin, mining gets harder as competition rises, making it more expensive. In exchange, miners take home rewards in the form of small bits of crypto every time they successfully verify a new block. These rewards, plus any other fees paid to the miners for exchanging mined coins add up to the value of crypto.
Cryptocurrencies were meant to be decentralized and free from government intervention. While central banks still have zero direct impact on the value of digital assets, governments have found ways to start regulating the usage of cryptocurrencies. El Salvador officially declared Bitcoin as a legal tender in September 2021. This step meant more acceptance of BTC, which would later see the demand for the asset shoot up and consequently its price. China on the other hand has banned Bitcoin since 2017 and has recently cracked down on Bitcoin mining rigs within the country. Considering that over 60% of the hash rate was in China, this crackdown discouraged global investors from getting involved in BTC. The price plummeted by more than 30%. This explains how the government’s acceptability of cryptos gives them value. The opposite is true.
Crypto developers create and adapt projects according to the user community’s needs. Governance tokens give holders the autonomy to make future decisions on a project, according to how many coins an individual holds. That means there needs to be a consensus before any decision is made. Investors prefer putting their money in cryptos with stable governance, where new decisions are not easily made. That guarantees them that they have a reliable place to put their money. Consequently, demand for such tokens rises gradually impacting their overall value.
Though the short term, the celebrity fad plays a role in the value of cryptocurrencies. Former president of the US Donald Trump has in the past launched a harsh round of attacks on Bitcoin causing its price to dwindle. Celebrity businessmen such as Elon Musk’s tweets are enough to crash or boom the crypto market. The Tesla boss tweeted in March “You can not buy Tesla with Bitcoin,” only to come back two months later and say that the decision was suspended. The market which had already risen by over 10% quickly plummeted following Elon Musks’ announcement of Tesla’s decision to stop accepting BTC.
Does Valuation Happen in the Crypto Market?
Stock traders use several factors such as an intrinsic value to determine whether or not to buy a share. In order to come up with these valuations, they take advantage of key company data. Annual profits, sales, and balance sheets, all contribute to the computation of important ratios and metrics to help a stock trader come up with investment decisions. Is it possible to value cryptocurrencies? The answer is yes. Crypto valuation isn’t very different from that of company stocks. The same ratios and computations used in the stock market price modelling are used in digital currencies too, only that the inputs vary.
- Inputs for the crypto valuation model
- Replace “Revenue” with “Total Annual Revenue”
- Replace “Earnings” with “Protocol Revenue”
- Replace “Book Value” with “Combined Locked Value”
- Replace “Share Price” with “Fully Diluted Market Cap”
With this information, you can use the same formulae used in stock market valuation to determine the price to sales ratio, price to earning ratio, and market capitalization to dollar value. These metrics can come in handy during strong price swings. For example, now that BTC has been going down since the beginning of the year, you may be able to find out if it’s undervalued relative to fundamentals, and determine whether you should start going long already.
As an investor, you should look for digital assets that are likely to gain value in the future. Calculating the intrinsic value of a coin, versus prevailing fundamentals might not be for everyone. A simple trick is to check the white paper and the total supply of a coin. A white paper is like a business proposal. It gives you the big picture, so you can determine whether that token has a future or not, based on its goals. On the other hand, checking on the supply of a coin might help you decide what kind of investment is suitable for different cryptos. For example, Bitcoin has a limited supply of 21 million, and about 19 million coins have already been extracted. Investing in a such a coin would be wise because soon the supply will be limited, while demand keeps rising. You may reap big from that.
Our website is a crypto library. There’s lots of reading material for everyone; from beginners to advanced crypto-maniacs. For today, here are some recommendations.
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