What is cryptocurrency really worth? Financial valuation tools and models are answering exactly this question. In our first post on this series, we introduced the factors that are used for valuation in crypto, followed by an intro to TradFi asset valuation. Now let’s get into how we can determine the value of crypto.

## Different Models to Value Crypto Assets

There are many asset pricing models and valuation methodologies in traditional finance that we can bring in for crypto assets valuation.

We summarised them in the following table:

Crypto and DeFi assets differ from TradFi – and so do their valuation models. There is no one-size-fits-all equation for crypto assets. Different cryptocurrencies have different characteristics and hence, require different methods for their valuation.

Here, we will introduce four methods, namely ‘Equation of Exchange’, ‘Discounted Cash Flow Model’, ‘Implicit Value Analysis’, and ‘Relative Value Analysis’ and explain how they can be applied to crypto assets, and add a crypto original at the end, the NVT Ratio.

### Value in Fiat: The Equation of Exchange

The equation of exchange is an economic identity that shows the relationship between money supply, the velocity of money, its price level, and an index of expenditures. English classical economist John Stuart Mill derived the equation of exchange, based on earlier ideas of David Hume.

It says that the total amount of money that changes hands in the economy will always equal the total money value of the goods and services that change hands in the economy.^{4}

Later economists restate the equation more commonly as:

Where:

M* x V = P x Q**M* = The money supply*V* = The velocity of money*P x Q *= Nominal Gross Domestic Product (GDP)

In crypto assets valuation, we use P x Q to represent the utility (i.e. GDP) generated or demanded for using the token. For example in Bitcoin, this can represent the demand for using bitcoin for cross-border remittance. For example in Ethereum, this can represent the demand for using Ether to pay gas for decentralised computing resources.

To use the above equation for crypto assets valuation, we need to change the equation a bit because the equation is only valid when we measure both sides in the same currency. For example, when we apply the equation to Singapore, we must measure everything in SGD, where *M* is the money supply for SGD, *V* is the velocity of SGD in Singapore, and *P x Q* is the GDP in Singapore.

Now, assume we apply the equation for bitcoin and everything is measured in BTC:

Multiply both sides of the equation by the BTC/USD exchange rate (represented by *fx*):

The supply of BTC is known. The velocity can be proxied by its on-chain activities. If we can estimate the size of its utility in USD, then we can estimate the price of BTC/USD. This approach is first formalized by Chris Burniske in his blog post ‘Cryptoasset Valuations’.^{5}

The equation of exchange is widely used for the valuation of various cryptocurrencies, including Bitcoin^{6}, Ripple^{7}, Filecoin, etc.

### Discounted Cash Flow Model – the Crypto Version

The discounted cash flow (DCF) model is not applicable for most cryptocurrencies (particularly payment tokens) since most of them will not generate explicit cash flow. However, tokens like Binance Coin or Huobi Token (i.e. asset tokens) do generate cash flows due to the token burn mechanism, hence they can be measured by the DCF model.

Assume we know the buy back amount (for token burn) at all future time points t, then we know the discount cash flow for these buyback amounts will be worth DCF_{0} at time 0.

Assume the market capitalisation (MC) is constant, by the equation:

*S* = Token supply*P* = Token price

We then have:

### Use Value: Implicit Value Analysis

If a digital asset is classified as a utility token, its value is given by the product or service accessed when it’s redeemed. Think of travel reward programs like Asia Miles or Avios where you can redeem air tickets by spending loyalty points.

Using our token CRO as an example, to estimate the price of CRO, one needs to take into account all the utilities (or perks) that can be gained by staking CRO tokens. These include:

- Reserving a premium metal card
- Receiving Crypto wallet benefits
- Get a 50% discount on fees in Crypto Invest
- Enjoy better APR (annual percentage rate) in Crypto Credit and Crypto Earn

Assume the utilities are defined by:

And the required investment to get those utilities are

*P* = Token price*T* = Token required

Then we have:

Note that there are many variations of implicit value analysis, to name a few:

- Utilities can be provided in different time points (so may require discounting)
- Various tiers may exist with different investment requirements and different utilities
- The tokens required for enjoying the benefits may be in different forms, like staking (ownership didn’t change, just locked for a certain period), spent (ownership back to service provider), or burnt (permanent decrease in token supply)

All these may affect the equation that you should use and readers should think carefully on how to formulate the equation.

### Comparing Apples with Apples: Relative Value Analysis

Relative value is a method of determining an asset’s value that takes into account the value of similar assets. This is in contrast with absolute value, which looks only at an asset’s intrinsic value and does not compare it to other assets. Calculations that are used to measure the relative value of stocks include the enterprise value (EV) ratio and price-to-earnings (PE) ratio.^{8}

### Crypto’s Very Own Valuation: The NVT Ratio

For crypto assets, since there is no balance sheet or income statement, the PE ratio can not be applied. Instead, in 2017, a crypto researcher, Willy Woo, suggested the Network Value to Transaction (NVT) Ratio in a tweet^{9}, and later formalised the concept in an article^{10}.

Here is a demonstration of the NVT Ratio:

In short, the NVT value tries to compare the token price against the value transacted in the network. The higher the value, the more speculative the asset is.

NVT Ratio only represents a relative value. We can use it to compare today’s value against historical values, or use it to compare tokens of similar kind (e.g. Ethereum vs EOS or Bitcoin vs Litecoin). However, unlike other methods we have introduced before, the NVT ratio cannot give an absolute number for the fundamental value of the crypto assets.

## Can You Model Reality?

While we suggest the methods above, readers should note that crypto asset valuation and pricing models are still a nascent area of research and more of an art than a science. Any output calculated by these models should be used for reference only.

All models are imperfect, many are useful. Even if the final result you get by applying these models is inaccurate, you might still discover patterns through the process of analysis. If you want to jump into one more crypto-specific model, learn about the Crypto J-Curve in the final piece of our crypto asset valuation series.

References

1. Chen, James. “How the Valuation Process Works.” Investopedia, Investopedia, 18 Nov. 2019, https://www.investopedia.com/terms/v/valuation.asp.

2. Chen, J. (2019, October 3). Time Value of Money (TVM) Definition. Retrieved from https://www.investopedia.com/terms/t/timevalueofmoney.asp.

3. Chen, J. (2019, July 15). Understanding Discounted Cash Flow (DCF). Retrieved from https://www.investopedia.com/terms/d/dcf.asp.

4. Chappelow, J. (2019, October 16). Equation of Exchange Definition. Retrieved from https://www.investopedia.com/terms/e/equation_of_exchange.asp.

5. Burniske, C. (2017, September 24). Cryptoasset Valuations. Retrieved from https://medium.com/@cburniske/cryptoasset-valuations-ac83479ffca7.

6. Ciaian, P., Rajcaniova, M., & Kancs, D. A. (2015). The economics of BitCoin price formation. Applied Economics, 48(19), 1799–1815. doi: 10.1080/00036846.2015.1109038

7. Mitchnick, R., & Athey, S. (2018, June). A Fundamental Valuation Framework for Cryptoassets. Retrieved from https://s3-us-west-1.amazonaws.com/fundamental-valuation-framework-for-cryptoassets/A Fundamental Valuation Framework for Cryptoassets_June 2018.pdf.

8. Chen, J. (2019, March 12). Relative Value. Retrieved from https://www.investopedia.com/terms/r/relative-value.asp.

9. Woo, W. (2017, February 24). Bitcoin Value to Volume Ratio. Retrieved from https://twitter.com/woonomic/status/835015883051298816?ref_src=twsrc^tfw|twcamp^tweetembed|twterm^835015883051298816&ref_url=https://cryptoticker.io/en/bitcoin-nvt-ratio/.

10. Woo, W. (2017, October 2). Is Bitcoin In A Bubble? Check The NVT Ratio. Retrieved from https://www.forbes.com/sites/wwoo/2017/09/29/is-bitcoin-in-a-bubble-check-the-nvt-ratio/#7dfdb2436a23.

11. Burniske, C. (2017, September 5). The Crypto J-Curve. Retrieved from https://medium.com/@cburniske/the-crypto-j-curve-be5fdddafa26.