Cryptocurrency, once a niche curiosity, has transformed into a global phenomenon. Its rise has been meteoric, with Bitcoin's price, for example, soaring from less than $1’000 in early 2017 to over $60’000 in 2021. Such explosive growth has captivated the imagination of investors, but it also raises crucial questions about how much cryptocurrencies actually should be worth. Hence in this article, we'll delve into a topic that gets talked about too little: crypto valuations.
Let's be clear upfront – this article isn't an endeavor to construct a valuation model à la Aswath Damodaran. Because when grappling with the enigma of cryptocurrency valuation, we find ourselves navigating uncharted waters in the vast ocean of finance. Rather, it's intended as a roadmap to help you comprehend the intricacies of crypto valuations and discern what to be mindful of before deciding whether cryptos are a market you want to be in.
Wild Frontier
The first time I seriously discussed Bitcoin was in summer 2017, when a hyped friend tried to convince me that his buddies just uncovered the secret to new riches. It reminded me of a salesman in the Mid-West during the Great Migration, trying to convince the sickened travelers to buy a bottle of snake oil from his wagon. I didn’t bite (yet). Still, I was intrigued enough to follow his invitation to a nightly seminar event. A few days later, amidst attendants from all kinds of backgrounds, a well-dressed Austrian took to the stage.
“Cryptogold," he exclaimed. His inexperienced, young disciples cheered. One hour later and the whole audience was up on their feet, clapping to the bringer of a new age: The Austrian Cryptoking. Afterwards there was a networking event, where a young group of Cryptogold-Holders checked the room for potential new investors. Meanwhile my friend walked cheerfully up to me: “Did you like it?”
It all begins with a whisper, a tantalizing rumor about a promising blockchain project that's been flying under the radar. The typical crypto investor, curious and never one to shy away from opportunity, decides to dig deeper. Hours turn into days as they meticulously research the project's whitepaper, scrutinize its team's credentials, and scour online forums for community chatter. The more they learn, the more convinced they become that this is a hidden gem, an undervalued treasure waiting to be discovered.
With conviction, they take the plunge, allocating a portion (or all) of their portfolio to this nascent venture. The excitement is palpable as they watch the price surge, seemingly validating their instincts. During a bull run, they decide to cash out, locking in substantial profits. This is the Wild Frontier, a place where fortune favors the bold and punishes the hesitant. In another scenario, our investor's initial optimism might turn to despair. The rumor could have been a mirage, the project's fundamentals weaker than they appeared, and the market sentiment suddenly shifting against them. Instead of riches, they find themselves counting losses.
In the world of cryptocurrencies, success and failure are often separated by a fine line, where every decision carries the potential for extraordinary triumph or bitter defeat. Yet technically speaking it remains a curiosity how a supposed currency can have a volatility like a .com stock in the 2000s. Thus before I dive into the value drivers and traps of cryptocurrencies, it’s important to understand that cryptos defy conventional asset categorization. Its very nature, whether it qualifies as a security, or a currency is still largely debated.
Neither Security nor Currency
Cryptocurrencies, such as Bitcoin and Ethereum, present a unique challenge when it comes to classification. They don't neatly fall into the category of securities or traditional currencies because they serve a fundamentally different purpose. Unlike stocks or bonds, cryptocurrencies are not tied to ownership or equity in a company. They lack the promise of dividends or interest payments that characterize securities. Instead, cryptocurrencies operate as decentralized digital assets, representing a new paradigm for value exchange and store of value.
In addition, traditional currencies are typically issued and regulated by governments and central banks, maintaining a degree of control over their supply and value. Cryptocurrencies, on the other hand, are decentralized and often operate on open source blockchain technology. They're not controlled by any central authority and are subject to supply limitations defined by their respective algorithms. This lack of centralized control and distinct purpose as a medium of exchange or store of value makes them distinct from traditional currencies.
Furthermore, the regulatory landscape surrounding cryptocurrencies is still evolving. Regulatory bodies around the world are grappling with how to categorize and oversee these digital assets. While some countries have classified certain cryptocurrencies as commodities or taxable assets, the debate over their precise classification rages on.
Value Drivers of Cryptocurrencies
Now that you got a feeling in what space we are operating in, let’s move on to the actual valuation of cryptocurrencies. Today the total coin market cap for cryptos stands at over $1 trillion. Hence people obviously ascertain value to these virtual currencies. This market valuation is mainly driven by three factors:
The Speculative Nature of Cryptocurrencies
Unlike traditional financial markets, cryptocurrencies are relatively new and lack many of the fundamentals that typically drive asset valuations, such as revenue streams or earnings reports. Instead, the crypto market thrives on speculation, with traders and investors often basing their decisions on future potential rather than historical performance. This speculative nature has led to both rapid price surges and dramatic corrections, making cryptocurrencies a high-risk, high-reward asset class.
One of the primary ways speculation influences cryptocurrency values is through the "greater fool theory", which posits that an asset's value is not necessarily derived from its intrinsic worth but rather from the belief that someone else will be willing to pay a higher price for it in the future. This mindset has led to a cascade effect, where investors buy into a cryptocurrency because they anticipate selling it at a profit to the next investor. The resulting speculative behavior can lead to extreme price volatility, creating opportunities for significant gains but also exposing investors to substantial losses.
Another phenomenon we often encounter in cryptocurrency markets is the classic "Fear of Missing Out", or FOMO. It's that irresistible urge, that nagging feeling that everyone else is getting rich on this new digital frontier, and if you don't jump in, you'll be left behind. Driven by the fear of missing out on the next astronomical rise, can push individuals to funnel their hard-earned money into cryptocurrencies with abandon.
The Role of Sentiment
In the world of cryptocurrencies, sentiment reigns supreme. Our emotions can steer us towards irrational investment decisions. Nowhere is this more evident than in the realm of digital currencies, where the influence of sentiment is nothing short of profound.
Social media platforms and online communities wield an extraordinary power over the ebbs and flows of cryptocurrency markets. A single tweet from a celebrity or a Reddit post can send prices on a meteoric ascent or a precipitous descent. It's a curious phenomenon obscuring the elusive concept of true underlying value. A prevailing aura of bullishness can propel prices to dizzying heights. Conversely, a cascade of negative headlines, regulatory crackdowns, or a wave of panic-induced selling can trigger a swift descent into the abyss.
Matter of Belief
But beyond sentiment, there exists another critical force at play in the valuation of cryptocurrencies – a matter of unwavering belief. Unlike traditional assets, fortified by tangible assets or tethered to government regulation, the worth of cryptocurrencies is inextricably linked to the faith of those immersed in this ecosystem.
Cryptocurrency investors are often ardent believers in the transformative potential of blockchain technology and decentralized finance. Their unwavering faith in these innovations can set in motion a self-fulfilling prophecy, wherein increased investment and fervent belief become the very crucible for augmenting cryptocurrency values. But there's a caveat. Any inkling of doubt, any hint of negative news, can send these faith-fueled valuations plummeting as belief wavers.
Uncovering Crypto Value Traps
Frequently crypto holders talk about potential, a promise of future application, utility, relevance whatever you like to name it. This per se is nothing new in the realm of investments. It has long been a common theme in the world of investments, where various assets are believed to appreciate due to certain expectations becoming reality, such as AI-driven stocks or real estate in up-and-coming neighborhoods nowadays. However, it's crucial for investors to be aware of three value traps that are particularly associated with cryptocurrencies:
Lack of Intrinsic Value Unlike traditional assets like stocks or real estate, cryptocurrencies often lack any inherent or intrinsic value. They aren't backed by physical assets or a predictable stream of future cash flows. Instead, their value primarily depends on market sentiment, speculative trading, and the willingness of other participants to buy them at higher prices.
In traditional finance, we typically assess a company's intrinsic value based on factors such as its earnings, assets, and growth potential. Who doesn’t love a good Discounted Cash Flow Model? However, when it comes to the crypto world, it operates under entirely different dynamics. Many cryptocurrencies are essentially digital tokens, and their value is determined by factors like scarcity, utility, and overall market demand. Because cryptos don't generate cash flows, produce goods, or offer services, the valuation risks in cryptocurrencies are substantial, as the asset is disconnected from any tangible economic activity. Nevertheless, the absence of intrinsic value doesn't necessarily render cryptocurrencies worthless, but it reduces the reliability to value these assets properly.
Lack of Utility as of Today In the crypto investment sphere, it's all too common to lose sight of cryptocurrencies’ core purpose. These digital assets were conceived to offer a decentralized and efficient solution to real-world problems; hence their true value lies in their utility. However, many investors fall into the trap of fixating solely on price predictions and market speculations, disregarding the fundamental role cryptocurrencies play in addressing genuine issues.
Cryptocurrencies with a clear utility-driven focus are more likely to prove resilient over time. Their real-world applications within the broader ecosystem are what truly matter. Amidst the hype, it's crucial to recognize that a significant number of cryptocurrencies currently offer limited real-world utility. While Bitcoin and a handful of others have established themselves as digital stores of value or mediums of exchange, most are primarily instruments for trading, rather than being used in everyday transactions.
The value of cryptocurrencies is heavily intertwined with their utility and adoption. Utility refers to the practical functions they serve in the real world. The more versatile and widely accepted a cryptocurrency becomes, the stronger the case for its valuation. Consider Bitcoin, for example. Initially designed as a decentralized digital currency, it has evolved far beyond that original concept. Today, it acts as a store of value, a hedge against inflation, and a tool for moving wealth across borders. Its adoption continues to grow, with institutional investors, payment processors, and even entire nations recognizing its importance. Furthermore, cryptocurrencies like Ethereum have ushered in an era of smart contracts and decentralized applications (DApps). These platforms enhance their utility by enabling developers to create innovative solutions on top of blockchain technology, expanding the potential for valuation.
An absence of meaningful real-world applications raises questions about the long-term sustainability and intrinsic value of many cryptocurrencies. For most, their valuations are driven primarily by speculative trading, rather than genuine use. It's akin to assessing a sports car solely for its speed potential without considering its practicality for everyday use. Until cryptocurrencies discover more widespread and impactful use cases, their valuations may remain divorced from their real-world significance.
It's worth noting that few people truly understand the entities behind these cryptocurrencies, and very few use the services these digital assets are supposed to provide in the long term. The argument that lack of regulation and oversight hampers their full potential is also perplexing, especially given that Bitcoin has been in existence for several years and has experienced multiple cycles of astronomical growth and subsequent crashes.
Scarcity and Supply Scarcity is a fundamental principle that has propelled assets like gold to lofty valuations throughout history. Similarly, cryptocurrencies often incorporate scarcity into their design, creating a sense of digital rarity. Bitcoin, with its capped supply of 21 million coins, epitomizes this concept.
The idea is simple: when a resource is limited, demand for it can drive up its price. Investors perceive cryptocurrencies with capped supplies as digital gold, something that can appreciate over time due to its scarcity. This perceived rarity encourages buying and holding, further affecting their valuations. However, scarcity alone isn't enough; it must be coupled with demand. A cryptocurrency with a limited supply that no one wants is unlikely to reach high valuations. Therefore, mere scarcity is a catchphrase often used by the latest crypto project, yet without long-term demand, even the scarcest currency is completely worthless.
Conclusion
In my personal journey, I transitioned from being a fervent advocate for cryptocurrencies to a steadfast doomsday critic. Yet, as time has marched on, I, like everyone else, find myself unable to predict with absolute certainty where the realm of cryptocurrency and its grand promises is truly headed. Recently, I engaged in a thought-provoking conversation with a former banker who challenged my belief that stocks are the real deal. Then he posed the question: “Aren't cryptocurrencies as real as stocks? After all, they are essentially just digital assets, a form of commitment, driven by the collective belief of its value.”
So, I'd like to conclude with this notion: Some individuals place their faith in gold as a hedge, while others believe in watches, stocks, obligations, real estate, art, and, indeed, cryptocurrency. Although I still personally lean toward investing in stocks or real estate over art and cryptocurrencies, it doesn't negate the potential viability of this market. If people are willing to invest in it, it undeniably possesses value, regardless of whether we
agree with the market or not.
What is certain however is that from a valuation perspective, cryptocurrencies are an absolute nightmare. Oh, and before I forget, the Cryptogold scheme at the beginning of this article was a fraud, and the Austrian Cryptoking never seen since.
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