How to Value Crypto Currencies?

Watching the business new channels these days is like watching a channel devoted to crypto currencies like Bitcoin. The returns that Bitcoin investors earned last year along with investors in other crypto currencies has been amazing. I have made a lot of money investing in these coins, but given my financial background I have recently been trying to evaluate if what we are seeing is true wealth creation or a speculative bubble that will burst spectacularly.

Traditional investing involves buying securities, ie stocks and bonds, in order to receive a cash flow either now or the potential of cash flows in the future. This expectation of a cash flow is what gives a security its value. In the case of a stock, one buys the stock expecting that the dividends from the company will give the investor a return over the life of the company that is acceptable for the amount invested. If the company has yet to provide a dividend then the value is determined by an expectation of a dividend in the future so that when the company's profits grow to a certain level a dividend will be paid and this will be enough to satisfy the investor for the amount they are paying for the stock right now.

Bonds on the other hand provide interest usually and then a maturity value so that the aggregate of these cash flows satisfy the investor for the amount they are investing initially. We saw some situations where interest rates went negative as a result of a rush to safety which meant that the aggregate of these cash flows is less than the initial outlay for the bond, a rare situation, but one that we did see occur.

With crypto currencies there is no expectation of some future cash flow. So when buying a crypto currency what is an investor expecting to receive from the coin, the answer is nothing. Investors in crypto currencies are hoping to sell their coins to some other investor for a higher price. So why would the price of the crypto currency rise or why does the investor expect it to rise? The usual answer is that the investor expects there to be a greater amount of users using the currency causing increased demand and this will lead to higher prices.

Currencies in traditional finance have actually been poor investments on their own. Owning fiat currencies and holding them is akin to taking money and leaving it in a chequing account that pays no interest. Over time the value of your money actually goes down because of inflation. Holding crypto currencies is similar to this. Now there are some crypto coins that pay interest or a return, however, this return is derived from newly created coins which causes inflation. These coin returns are similar to a stock dividend or stock split and on the whole should not increase the investor's return, the aggregate value of their coins should be the same as before the coin dividend as nothing fundamentally has changed with the coin, the value is just divided by more coins.

So if fiat currencies on their own have generally been poor investments, why would crypto currencies be different. Well currencies relative to other currencies can increase if their demand goes up by a greater amount than the demand for the currency they are paired with. If interest rates in the US increase and interest rates stay constant in Europe than all else being equal demand for US dollars will increase thus causing the value of the US dollar to increase versus the Euro. If the demand for Bitcoin increases more than Canadian dollars because Bitcoin is accepted at more retailers then the value of Bitcoin relative to Canadian dollars will increase.

In 2017 the value of many crypto currencies increased dramatically mainly because of increased demand as a result of speculation of future higher demand because of higher usability. I think over the long term crypto currencies will have to get used for reasons beyond speculation and for actual real world issues where they provide some real benefit. Their value will be determined by this level of real world usability and growth in their value will come from the growth in usability. Once the coin is being used and the amount of usability reaches its peak and stops growing than the value of the coin will also stop appreciating. Right now demand has come from speculation of higher usability. Real world usability will increase for many crypto currencies and as they mature speculation of future usability will slowly decrease so the price of crypto currencies will depend on the total demand (real world use + speculation) and whether this grows or decreases. If speculation turns out to be greater then the actual real world use of the coin then the value of the coin will decrease as total demand decreases over time.

I think measures of usability will be created and this will benefit the analysis of crypto coin values. With these measures coins can then be measured in terms of their usability versus their current price. This will be similar to how we measure stocks using the earnings of a stock and measuring this versus the stock's current price, like the price to earnings ratio. Once these measurements are determined we can then compare them among different crypto currencies to see how they compare and make assessments if a crypto currency is under valued or over valued. I think once these tools are created it will give the market greater confidence regarding the values it places on crypto currencies.