In a previous post, we gave you the low down of which factors influence the value of a cryptocurrency. Here we get into some actual financial analysis tools and models to determine the value of an asset. Before moving on to crypto assets valuation, it is good to have the full picture of how traditional assets such as bonds, stocks, and options are evaluated.
Asset Valuation & Financial Models
First, let’s introduce you to two classic and widely used financial valuation techniques: the time value of money and the discounted cash flow model.
The Power of Now: The Time Value of Money
The time value of money (TVM) is the concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also sometimes referred to as present discounted value.2
The formula for present discounted value is:
For example, assuming a 5% annual interest, $1.00 in a savings account will be worth $1.05 in a year. Inversely speaking, if a $1.05 payment is delayed for a year, its present value is $1 because you will lose the interest that can be earned to put it into your savings account, this is otherwise known as the opportunity cost.
Planning for the Future: The Discounted Cash Flow Model
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flow.3 It is a widely used financial valuation technique used for fixed income assets, stocks (in the form of dividend discount model) or even derivatives.
Assuming interest rate is i, with future cash flows CFt at each of the time points t. The discounted cash flow at time 0 is therefore:
The discounted cash flow model is basically the sum of the present discounted value for all future cash flows.
See the example below:
Traditional Financial Assets for Investment & Their Valuation
These two models gave you an intro to financial valuation, but (of course), it gets more complicated than that. Pretty much every asset class has its own valuation model. Here we introduce how to valuate three basic ones: Bonds, stocks, and options.
Playing it Safe: Bonds
A bond is a fixed income instrument that represents a loan made by an investor to a borrower, typically used by companies, municipalities, states, and sovereign governments to finance projects and operations. Bonds are typically evaluated by using the discounted cash flow model.
Zero coupon bond
Some bonds do not make any coupon payments but are sold to investors at a discount from face value instead. The pricing formula is shown below:
Coupon bearing bonds
For coupon bearing bonds, they are just basically adding the (discounted) coupons value on top of the face value.
C = the periodic coupon payment
i = discount rate
F = the bond’s par or face value
t = time
T = number of periods until the bond’s maturity date
Classic Investment: Stocks
A stock refers to a share of ownership of a publicly-traded company. To evaluate a stock’s price, one of the common ways is to review a company’s P/E ratio when we determine if the share price accurately represents the projected earnings per share. The formula is shown below:
Price-to-Earnings Ratio (P/E ratio)
It indicates the dollar amount an investor can expect to invest in a company in order to receive a dollar of that company’s earnings.
Dividend Discount Model (DDM)
Another way to evaluate a stock’s value is by the Dividend Discount Model. It calculates a stock’s value by the discounted sum of all of its future dividend payments.
DDM is only applicable to companies that pay regular dividends, but not companies with fluctuating dividend growth rates or no dividend at all.
Advanced Trading: Options
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. It involves complicated calculations when we evaluate an option and The Black Scholes model is one of the most common ways to price an option.
The Black Scholes Equation
The Black Scholes equation is a mathematical model for pricing an options contract. It estimates the variation over time of financial instruments and uses the implied volatility of the underlying asset to derive the price of a call option.
It calculates the price of a call option by weighting the current price of the underlying asset with the probability that the stock price will be higher than the exercise price and subtracting the probability-weighted present value of the exercise price.
C = Call option price
S = Current stock (or other underlying) price
K = Strike price
r = Risk-free interest rate
t = Time to maturity
N = A normal distribution
To make it easier to understand the equation, we can simplify it to the following equation:
From this equation, we can clearly understand that the value of a call option at expiration equals the spot price of the underlying asset minus the present value of its exercise price, considering the probability that the option will be higher than the current stock price based on our expectations.
N(d1)and N(d2) represent the standardized normal distribution probability that a random variable will be less than d1 and d2, respectively.
There are several assumptions in the Black Scholes model:
- The option can only be exercised at expiration, i.e. European
- Efficient market conditions
- No transaction costs involved
- Risk-free rate and volatility are constant
- Normally distributed returns on the underlying asset
From Valuating TradFi to Valuating DeFi
DeFi is different, no doubt you already know that and that’s why you are here. Next, let’s look at how cryptocurrencies are evaluated.
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3. Chen, J. (2019, July 15). Understanding Discounted Cash Flow (DCF). Retrieved from https://www.investopedia.com/terms/d/dcf.asp.
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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/.
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