Crypto Is Indeed Growing. Here’s How We Can Add Value To It

A more specific and nuanced approach will be extremely useful for valuing crypto assets, and for investors to make a more informed decision.

The growth in cryptocurrency has been phenomenal over the last decade.

Source : Getty

By Pankaj Sharma

The history of cryptocurrency isn’t that long, but because of its volatility and huge investor interest, it’s arguably one of the most absorbing stories in modern finance. It is also a fact that cryptocurrency has continued to remain a controversial topic almost since its beginning.  While the supporters emphasise the decentralised power of cryptocurrency, its critics highlight the lack of transparency as a major concern. The critics also worry that lack of accountability and no credible use case makes cryptocurrency inherently unstable, volatile, and prone to abuse. 

Nevertheless, the growth in cryptocurrency has been phenomenal over the last decade. The global cryptocurrency market cap now is more than $1.5 trillion, which is almost double the market size one year ago. More surprisingly, the total cryptocurrency market cap is still significantly down from its peak of 2021, The cryptocurrency market cap had hit the $3 trillion mark in 2021 and still, there is a long way to go before we reach those levels again. 

The numbers for India on crypto assets are no less astonishing. The estimates suggest that there are around 120 to 150 million crypto users in India and the country is perhaps only behind the United States on cryptoassets trading as well as mining. The value of crypto assets held by Indians is most likely in the range of $250 and $300 billion, as per several different available estimates. 

It is an undeniable fact that extreme volatility and high adoption of crypto assets have led to contrasting opinions on how to value cryptocurrency. For cryptocurrency, a robust and conceptually sound valuation assessment is even more relevant in a country like India, which has a long way to go in financial literacy and investor awareness in general. A more specific and nuanced approach will be extremely useful for valuing crypto assets, and for investors to make a more informed decision. 

The fundamental characteristics of crypto assets vary, including their definable cash flows, estimated growth rates, network effects, and tokenomics. These characteristics influence the development of valuation models, some of which can be adapted from traditional finance, while others are specific to the characteristics of a particular crypto asset. 

When it comes to smart contract platforms, there are two main approaches to valuation. The first is to treat the platform as a cash flow asset where transaction fees can be measured. For example, consider Ethereum, the blockchain platform for smart contracts. Cash flows include the portion of fees paid to validators of transactions on the blockchain, while the portion of transaction fees ‘burned’ by removing tokens from the available supply may be considered akin to a share buy-back in traditional finance. By calculating these cash flows along with estimates of growth rates and discount rates, an analyst can estimate the present value of future cash flows to value Ethereum.

An alternative approach to discounted cash flow analysis is to consider a platform as a network. In this case, a qualitative framework based on on-chain data can be used to assess it on a relative valuation basis by comparing valuation multiples among smart contract platforms. Additionally, Metcalfe’s law, which values a network based on the square of its number of users, can be used to value it relative to its market capitalisation.

Similarly, decentralised applications such as decentralised exchanges can be valued either with a relative valuation approach or an intrinsic value approach using the discounted cash flow model. For example, in the case of relative valuation, benchmarks such as price-to-sales, price-to-fees, and market capitalisation to net asset ratios can be used to value decentralised applications within the same sector or to compare them with their traditional finance counterparts.

Let us also look at the specific case of Bitcoin, the largest crypto asset with ~50 per cent share of the total market capitalisation of cryptocurrency. Currently, Bitcoin has the most literature covering the question of how to value it. Models most practitioners rely on include, for example, the total addressable market approach which is used to value bitcoin against comparable assets that satisfy the properties of money; Metcalfe’s law; and the cost of production model, which considers bitcoin as a virtual commodity and assumes that the marginal cost of its production determines its value. These models take differing viewpoints on whether Bitcoin represents a store-of-value or medium-of-exchange. However, basing valuation on just one of Bitcoin’s fundamentals leads to limitations. 

The crypto asset market is dynamic and despite volatility, it has shown resilience amid several high-profile scandals and business failures. A valuation approach which is consistent and robust will position investors to navigate the ever-evolving crypto landscape successfully and could help ensure that they don’t make costly mistakes.

(The author is the Senior Manager for Capital Markets Policy, India at CFA Institute)

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