Pricing crypto-assets is a hot and challenging topic provided their high volatility, their unprecedented asset class and the poor perception of their intrinsic value. Let's review three popular approaches to value them: valuation based on equation of exchange, valuation as a currency, and valuation based on network value.
Top 10 crypto-assets price as a % of all-time high
Valuation based on cost of production
The production of mineable crypto-assets like Bitcoin is akin to a competitive market. In theory miners will produce until their marginal costs equal their marginal product. Therefore, instead of approaching them as a digital money or currency, it is perhaps more appropriate to consider them a virtual commodity with a competitive market of producers. This could help derive their intrinsic value.
In this perspective, Adam Hayes identified key variables driving the decision to mine: (1) the cost of electricity, (2) the energy consumption per unit of mining effort, (3) the monetary price of the crypto-asset and (4) the difficulty of the mining process. Based on these inputs, he proposed an economic model of the decision to mine crypto-assets, resulting in the following formula of their price:
Crypto-asset price = Cost of mining per day / Production per day
Where the cost of mining per day is a function of mining power and electricity price, and production per day is a function of mining power and the difficulty of the mining process.
It is important to bear in mind that Hayes’ model does not capture all factors that could impact the mining decision, e.g. subjective factors such as miners’ speculation. Furthermore, speculation and velocity certainly add a significant component to the market value of crypto-assets.
Valuation based on equation of exchange
The equation of exchange formula is a framework derived from the works of Irving Fisher. It can be used value a currency based on the acceptance and speed of economic transactions in the macro-economy.
Chris Burniske was among the first people to suggest that crypto-asset be valued using this formula. Here is how it look like:
MV = PQ
Where M is the size of the monetary base or supply; V is the velocity of the crypto-asset; P is the price of the crypto-asset; Q is an index of real expenditures.
Valuation based on network value
Ethernet founder Robert Metcalfe proposed that the value of any network is proportional to the square of its number of nodes. The theory is that a network has little or no value with just one or two users, however with each new user, the utility value of the network more than doubles. When applied to large social networks such as Facebook, research suggest that this relationship be accurate.
In this perspective, the value of crypto-assets such as Bitcoin could be measured by relying on Metcalfe’s law. Tom Lee, a former strategist at J.P. Morgan, stated in november 2017 that “If you build a very simple model valuing Bitcoin as the square function of the number of users multiplied by the average transaction value, 94% of the Bitcoin movement over the past four years can be explained by that equation.”
To calculate the value of Bitcoin under Metcalfe’s law, one could use the following formula:
Value of Bitcoin = Unique Addresses^2 * Volume per account
Where Unique Addresses represent the number of unique bitcoin addresses participating on the network per day, and Volume per account represents bitcoin transaction volume per day.
Check the full version of Blockchain Quarterly (Q1 2019) report for more Insights.