Valuing Cryptocurrencies

Valuing Cryptocurrencies

No assets have given so much hype as cryptocurrencies in the last few years. The concept of cryptocurrency started with Bitcoin after the global financial crisis in 2007 when Satoshi Nakamoto wrote a paper on the need for an alternate currency to protect citizens from future banking scams. Since then, multiple cryptocurrencies, like Ethereum and Polygon, have existed. In addition, cryptocurrency exchanges have started that allow the trading of cryptocurrencies. However, recently cryptocurrencies were in the news for becoming the medium of exchange for terror organizations and extortion activities. Yesterday, US DOJ seized $3.36 billion of bitcoin from a man who unlawfully obtained 50,000 bitcoins from the dark web. Further, prices of cryptocurrencies were highly volatile, with Bitcoin price climbing to a high of $64,400 in November and then declining to $18,948 in July 2022. In this post, I provide my insights on valuing cryptocurrencies, their future, and whether they can substitute fiat currencies.

Cryptocurrency – An Asset, Currency, Commodity or Collectible

You cannot value everything, but you can price everything. So when I make this statement, I need to provide a distinction between price and value.

We can value any asset that generates cash flows. For instance, I can value a bond that provides coupons and face value at maturity. Likewise, I can value equities because it gives dividends, and their equity claim appreciates when the firm does not. I can value these cash-generating assets by discounting the expected cash flows at a rate that denotes the risk of the underlying cash flows. Thus, assets with high cash flows and low risk have a higher value than assets with lower cash flows and higher risk.

Another way to evaluate an asset is that I can price assets by scaling them to a standard metric. For instance, I can price stocks with multiples like P/E, EV/EBITDA and EV/Sales. After that, I can pick stocks that are cheaper than others.

A commodity’s value derives from its use as a raw material to satisfy a need. For instance, iron ore is a commodity used to manufacture pellets and rods used as raw materials by other industries. Commodities are cyclical and depend on the momentum of the economy. There are futures that price commodities on their demand and supply. Thus, we have commodity futures from wheat, oil and coal.

A currency is a medium of exchange used to denominate cash flows. Currencies determine purchasing power. However, we cannot value currencies because it does not generate cash flows. However, we price currencies on their exchange power and currencies with high purchasing power are stronger. In reality, we do not determine currencies by demand and supply because governments manipulate exchange rates to weaken or strengthen their currency. For instance, to reduce the high inflation rate, Fed has increased interest rates resulting in sucking excess USD from the system. As a result, the USD has strengthened against other currencies.

A Collectible is an art/painting that carries an aesthetic value. It has no cash flows and is not a medium of exchange. Therefore, its price depends on the demand and supply. Thus, Da Vinci paintings with high desirability but low scarcity carry a higher price.

What Is Gold

As I have made a distinction between Assets, Commodity, Currency and Collectible, the next question is how we treat Gold and Real estate. Gold does not generate cash flows; on the other end, it is also not a commodity. Some might argue that Gold is a raw material for jewellery, and thus Gold is a commodity. I differ in that view because people buy Gold to hedge their risk against currencies. So during high inflation, when the currency power decline, people look at Gold as a storehouse of value. Thus, I classify Gold as an alternative currency than a commodity.

When we look at real estate, we can value it as an asset because it generates cash flows as a rental income. However, valuing real estate is challenging because people price it on location, per sq. ft and the builder’s reputation.

Cryptocurrencies – An Investment Or Trading Asset

As discussed earlier, we can value and price assets, commodities, currencies and collectables. As an investor, I value the investment and then compare it with the price I pay to acquire it. I decide to buy if the price is less than the value and sell if the price is more than the value. On the contrary, trading is simple, where you look at the price and judge whether the price will go up or down in the future. We have investors and traders in the stock markets.

In the table below, I have differentiated Trading and Investing. This difference is because the skill sets needed to become a trader and an investor differ.

Defining Cryptocurrency

From the above sections, we need to decide if cryptocurrency is an asset, commodity, currency or collectable. Cryptocurrency is not an asset because it does not generate cash flows. Further, it is not a raw material for a final product. Some might refute my argument by saying that ethereum is a vital component of smart contracts. If we take that argument, then cryptocurrency is a commodity. However, cryptocurrencies’ absolute positioning is that they are an alternate currency for fiat currencies. When I view cryptocurrency as an alternate currency, there are two issues. First, not many people use it as a medium of exchange. Second, it is highly volatile. If things change in the future when more people accept cryptocurrencies as a medium of exchange and if they become stable, they can become a potential alternative to fiat currencies. This assumption is unrealistic, especially when many countries have banned cryptocurrencies as legal tender. Banks globally have to introduce regulations to monitor cryptocurrencies to make them easier to use.

Can we use Cryptocurrencies as an alternative to Gold?

People invest in Gold because they lose trust in the government and currencies during higher inflation. Further, as the supply of Gold is limited, it will always retain its value. Similarly, bitcoins are limited in number as we can mine 21 million bitcoins. Therefore, if more people are interested in buying bitcoin as a storehouse of value, then bitcoin can become an alternative to Gold. However, in the COVID-19 crisis and the recent market meltdown, the price of bitcoin has plummeted during the stock market crashes and has increased during the boom. Thus, cryptocurrencies are not a hedging bet like Gold.

Thus, i conclude cryptocurrencies as a speculative trading asset that attracts money from speculators who want to make quick profits. It is the 21st-century Tulip Bulb – a speculative asset whose prices soared in the Netherlands during the 16th century before collapsing.

Final Thoughts

I conclude this article with the following closing arguments:

• First, cryptocurrencies are not assets; In the Modern portfolio theory, we invest in multiple assets for diversification. However, cryptocurrencies have a positive correlation with equities. At best, it is a speculative asset that traders use for making quick returns.
• As Cryptocurrencies are not assets, you cannot value them. Therefore, anyone who values a bitcoin is fooling you because it does not generate cash flows.
• Cryptocurrency can become an alternative currency when it is accepted as a medium of exchange and becomes stable. However, the probability of that happening is low.
• As an investor who believes in value, cryptocurrency is not a suitable investment because its price fluctuations have nothing to do with the fundamentals but with the mood and momentum.

Thus, anyone with cryptocurrencies as an investment may profit millions and lose millions if the momentum changes.