As a member of the crypto investor community, I can say there’s been a lot of discussion on how an investor should go about fundamental analysis for cryptoassets. We see a lot of discussion about technical analysis all over the Internet from Facebook groups to Reddit to #CryptoTwitter. Chris Burniskeput out a great book, “Cryptoassets: The Innovative Investors Guide to Bitcoin and Beyond” and it was the first time I heard the word “cryptoassets” instead of cryptocurrencies to describe assets using blockchain and other distributed ledger technologies. In his book, he lays out a good case for how to go about fundamental analysis.
For me, most of the fundamental analysis I do revolves around network activity. Most of these cryptoassets are networks either logically or physically. Some of blockchains that are a collection decentralized nodes running the same open-source code. These nodes communicate with one another to keep all the same information in lock-step so that all nodes record the same data and in the same order. These are physical networks. Other cryptoassets are tokens running protocols. Their users are networked together providing some protocol or service. They run on a blockchain platform like Ethereum or EOS, but the tokens themselves aren’t blockchains. These cryptoassets are still networks though they are logical networks.
Regardless of whether a cryptoasset is a logical or physical network, the primary value of a cryptoasset is derived from being a network. Most in the crypto-community subscribe to the fact that cryptoassets glean value via network effects. A network effect is the positive effect described in economics and business that an additional user of goods or services has on the value of that product to others. If network effects exist for cryptoassets then Metcalfe’s Law is playing a role in how to value these assets.
If we’re to use that fact that network activity is the key to understanding the derived value of cryptoassets, then we need to understand Metcalfe’s Law. It states that the value of the network is proportional to the square of the number of connected users. Simply put, as more and more people use a cryptoasset, the higher the value because of the network effect. As the number of users grow linearly, the value of the network grows geometrically. For example and roughly speaking, if the number of connected users of a network doubles, then the value of the network goes up by 4. This is why it’s key to understand network activity so that we can take a fundamental approach to valuing cryptoassets. The non-linear growth capability is key to understanding the value of cryptoassets.
7 Indicators & Ratios Used for Fundamental Analysis
At my firm, we use fundamental analysis as one of three aspects in our approach to investing. We use the following 3 indicators and 4 ratios.
- Unique Addresses (Daily)
- Transaction Value (Daily)
- Mining Cost (Daily)
Each indicator shows a trend — rising , falling or holding . If they are rising, that’s bullish. If they are falling, that’s bearish. If they are holding, that’s neutral.
- NVT Ratio — Bullish is <15 & Bearish is >25
- MVRV Ratio — Undervalued is <1.5 and Overvalued is >3.5
- Mayer Multiple — Bullish is <1.0 and Bearish is >2.4
- Mining P/BE Ratio — Bullish is <1.2 and Bearish is >3.2
Each of these ratios have two thresholds, an upper threshold and a lower threshold. Others may use different thresholds, but these are the factors we’ve found to be best for our decision making. Let’s explore each a little more.
Network Value to Transactions (NVT) Ratio — The P/E Ratio of Crypto
One of the most basic ratios to understand for fundamental valuation of cryptoassets is the network value to transactions ratio. This ratio divides the network value, what would be considered the market cap in the equites space, by the network transactions. We want to see the relationship between the value of the overall network and how it relates to the network’s activity. This ratio is typically called the “P/E Ratio for crypto” because it’s one of the most basic metrics to determine fundamental value. If a cryptoasset has a very high network value (i.e. market cap) and low network activity, then it’s going to have a high NVT ratio. If a cryptoasset has a medium network value and high network activity, then it’s going to have a lower NVT ratio. The latter may indicate value is present because again, we’re analyzing network activity and always considering Metcalfe’s Law and network effect.
From: Coin Metrics / coinmetrics.io
Network Unique Addresses (Daily) Indicator
Unique addresses is an important basic indicator because it shows how many people are using the network in any given day. We want to observe this indicator to see the trend. If the trend is up and network usage is up then we can expect the value of the network to go up. Conversely, if we see that the unique addresses are down, then usage is down and we can expect the value of the network to go down. If we look back at the definition of Metcalfe’s Law, we see that the number of users plays an important role in determining the value of a network. Instead of trying to ascribe an exact network value to each number of users, we use the trend — are more people using the network that day or less?
Network Transaction Value (Daily) Indicator
Analyzing unique addresses used daily only gets you half of the picture in regards to network activity. If you want to evaluate value, then you also need to look at how much value is being moved over a certain time period. The Network Transaction Value indicator gives you a trend on whether the value moved over a network is rising, falling or stable. If the daily value is rising then the overall value of the network too should be rising. Conversely, is the value if falling then the network value too is falling. This indicator is used to mark a trend; it’s not used to any valuation metrics or process. The more value is being moved through a network, the more valuable the network.
Market-Value-to-Realized-Value (MVRV) Ratio
The MVRV Ratio is a more specialized version of the NVT Ratio. It’s a ratio between a network’s market value (market cap) over its realized value. Realized value is a calculation of market cap where coins and price are based on the market price of BTC when each coin last transacted on the blockchain. This removes lost coins and establishes a price for a cumulative cost basis that helps an investor see the true price support levels based on past trading. Lost coins skew the averaging calculations and the MVRV ratio attempts to cure that skewing. This ratio was created by Nic Carter of Castle Island Ventures and outlined in the article, “Bitcoin Market-Value-to-Realized-Value (MVRV) Ratio”. This ratio works because it gives use a better view into the value of a network by excluding some edge cases.
Mayer Multiple Ratio
The Mayer Multiple is one of the more established ratios after the NVT Ratio. It was named after Trace Mayer, one of the first Bitcoin investors and analysts. It is a statistical estimator which shows how common a price level is in relation to its historical trading patterns using the 200-day moving average. Simply put, the Mayer Multiple:
- Mayer Multiple = Price / 200 DMA (200-day moving average)
For example, today the Mayer Multiple (MM) is 0.89 ($6,373.85 / $7,142.22). You can easily check the daily Mayer Multiple at this Twitter account, @TIPMayerMultiple. If the MM < 1.0, it’s Bullish and if the MM > 2.4, it’s Bearish. The account also backtests the data each day with the new values to show what percentage the indicator is right for an investment today and 1 year layer. Today, with a MM of 0.89, it’s higher 77% of the time one year later compared to today’s price. This ratio is valuable because it predicts value a year later more often that not.
From: WooBull Charts
Price to Mining Cost Breakeven (P/BE) Ratio
The price to mining breakeven ratio compares the price of a cryptoasset relative to the cost to mine. This ratio only works for coins that are mined, not tokens or coins that are pre-mined. Most of the time, this ratio is being used with one of the reserve cryptoassets, bitcoin or ether.
For example, if bitcoin is trading at $6,400 and the mining breakeven price is $7,000 then the P/BE Ratio is 0.91 (6400/7000). If the ratio is < 1.2 then the ratio is bullish and if the ratio is > 3.2 then the ratio is bearish.
The reason why this ratio has merit is twofold. One, the mining system is a closed, dynamic system always looking to reach equilibrium. If the cost of mining is higher than the price, then some miners will quit mining because it’s not profitable. They’ll wait until the numbers make sense to mine. If the price is way higher that the cost of mining, then it will start to bring in new miners who see the high profitability potential. Those new miners, will force the algorithm to increase complexity making it harder and more expensive to mine. This is the crux of the proof of work consensus mechanism. Two, this ratio is used because, when backtested, it works. Research work done by Fundstrat shows the percentage chance it is correct when looking at the price of bitcoin one year later. This ratio and the relationship between price and mining cost is hotly debated. Some don’t believe there is a relationship between the two.
Mining Cost Indicator
At the height, we were paying over $50 per settled transaction on the Bitcoin network. You could see that the Mining Cost Indicator was falling in mid-January. It was easy to see transaction fees were drastically falling and that’s because network activity was crashing. With less network activity, we can expect the value of the network to crash as well. This was a bearish indicator for the Bitcoin network.
Now, you’ll notice in the graph below, that the trend starting to rise in August of 2018. There seems to be more demand and more network activity and the trend seems to be rising. This was a bullish indicator for bitcoin.
As you can see, mining cost is an important indicator giving you 1 dimension of many to consider when getting the total picture of what’s going on in the markets.
At Tradecraft, we use these 3 indicators and 4 ratios in the core framework of our fundamental analysis. Right now, cryptoassets are so correlated that we’re using the Bitcoin network to determine a macro view for the entire crypto market. These metrics are not currently being used to evaluate each cryptoasset. That may change in the future, but it’s working for a general view right now.
Here’s a summary view of the Tradecraft Crypto Fundamentals Framework (TCF) for Q4 of 2018:
Using these indicators, I believe the crypto markets have bottomed and they’re showing value. I would want to look deeper into daily transaction volumes and daily transactions to see if they represent risk that needs to be factored into the investment strategy. Overall, the fundamentals currently look good for the crypto markets.