Crypto-Analysis 2018: How to Fundamentally Value Ethereum

November 27, 2018  |  
Oscar Loudon

It appears that cryptocurrency is at the exact same point in time as when the stock market was booming in the 1920s. During this time, stocks would trade purely on sentiment. At this time, companies with little to no earnings would be able to raise millions of dollars, and in turn the market boomed. In economic context, many parallels can be drawn between this time and the time that we are currently living. The exact same behaviours that occurred during the 1920s and the lead up to the great depression can be seen to be acting out in the cryptocurrency space right now.

Who said history never repeats?

But first, let’s set the scene.

During the 1920s, people seemed to completely ignore the fundamentals that kept stock prices honest. For speculators on the market, a company did not need anything more than news, and a bit of hype to be worth investment.

Following the great crash of 1929, Ben Graham wrote a book called, ‘Security Analysis’. This book made the distinction between speculation and investment, and then taught readers what to look for to make an investment portfolio. Of course, Ben Graham fully acknowledged how long it would take to make an investment portfolio. It also became clear that Ben Graham was not interested in speculation at all. In fact, he loathed the investment communities’ obsession with news.

Graham saw investing as: An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are therefore speculative.

Graham proposed that investors look at three key metrics:

  1. Price to earnings ratio
  2. Dividend yield
  3. EBITDA

Graham himself clearly stated that a stock was a partial ownership in a business, and by extension a business model, management team and underlying technology.

These seemingly small, but fundamentally important parts of investing have formed the basis of many investment portfolios. And it is with this understanding that we can build a platform for trading Ethereum.

A brief history on the crypto-bubble

I believe that hindsight will prove that cryptocurrency investment at this current period would provide some of the best investment returns. Though Bitcoin in itself has grown substantially, and held its value over a long period of time, it is in fact highly unlikely that Bitcoin will grow to a market cap beyond $1T USD in the next two decades (still a substantial amount of money by anybody’s measure). Ethereum on the other hand would be likely to hit $1T over this time.

In late 2017 and early 2018, prices of cryptocurrencies skyrocketed. Not only did they skyrocket, but their prices were not based on anything other than pure speculation and hype. Coupled with this, the Ethereum standard ERC-20 gave way for many, many initial coin offerings to be launched. Under the ICO model, companies could raise money under the proviso that they would build the project that they were proposing. ERC-20 allowed for proposals to be created, and funds to be raised for utility tokens.

Utility tokens frankly offered no value. They added friction. In fact, as Fred Scherbesta of Finder.com stated, ERC-20 was the tulip that caused the bubble.

People who invested in cryptocurrency now find themself in the precarious position where they don’t know what they need to do to make money, and lack the basic information to make an informed decision as to what they can do with their money. Most ICO projects will never make it to fruition, leaving the market decimated, bare and with seemingly little to no hope of recovery.

What is therefore desirable, with all historical considerations in place, is a system that allows users to actively purchase cryptocurrency, and if the price falls, allows them to freely move their money to a safe haven. In essence, this system would allow you to bet for and against cryptocurrency depending on your position in the market (whether you owned the crypto-asset or the cryptocurrency).

The Metrics behind Ethereum

When people buy cryptocurrency, they must firstly understand that they are not buying a currency in the strict sense, but they are buying a share in a network.

Cryptourrency, therefore by definition may be considered to be a fractional ownership in a network, with the network size itself attributable to the amount of data nodes (read: merchants) in the network. This simple idea seems to be virtually unbeknownst amongst cryptocurrency enthusiasts.

Though the following principles may be applied to all cryptocurrency, we have chosen to focus almost exclusively on Ethereum. The reasoning behind this is due to the presence of decentralised applications, known as d-apps, giving a clear use case for Ethereum above other cryptocurrencies.

The Ethereum network allows users to construct applications for smart contract execution, using a programming language called Solidity. Solidity is a programming language specifically designed for the Ethereum Virtual Machine (EVM). When a contract is verified on the Ethereum blockchain, a small amount of Ethereum (known as gas) is paid out. Unlike Bitcoin, Litecoin, and other cryptocurrencies, Ethereum allows users to deploy smart contracts that can be verified on the EVM (read: blockchain).

The Opportunity in Ethereum

Ethereum presents a rare opportunity for cryptocurrency investing. Not only is Ethereum widely utilised, but given the current price ($204 USD as at 19/10/18), it may be considered undervalued given thorough ratio analysis.

If we really look at the price performance of Ethereum over the last year, at its peak Ethereum represented an exceedingly high gas price with very little actual transactions. During the ICO bubble, ERC-20 compliant contracts flooded the market. As ERC-20 utility tokens does not represent any actual value, Ethereum could have been considered overvalued at this time.

Now, with the ICO market having wiped out most of the overpricing from Ethereum, Ethereum may be considered undervalued. Ethereum is a very powerful tool, that is going virtually unnoticed due to the prevalence of ICOs.

The question remains as to how ethereum may be considered may be considered undervalued. Traditionally, for a particular company to be considered undervalued, it must be thoroughly analysed with a view to discern its value from the available metrics.

How to value Ethereum

Though these metrics have been around since the beginning of 2018, since the crash of all cryptocurrencies, they have not been widely published.

These metrics are as follows:

NVT — Network Value to Transaction ratio

PMR — Price to Metcalfe Ratio

GSR — Google Search Ratio

They will be touched on further on in this, but it is important to understand that there is an inherent opportunity in aggregating and broadcasting the key metrics in Ethereum, which has not been done before.

The Network Value to Transactions Ratio:

Chris Burniske, the author of the book Crypto-Assets (one of the definitive books on cryptocurrency) gave the suggestion of using the term “Network Value to Transaction ratio” as a similar concept to a P/E ratio for valuing companies. In October 2017, Willy Woo (himself a significant powerhouse in the cryptocurrency space) gave the concept some significant modifications to produce a more accurate reflection of the network value.

The concept is simple enough. If a cryptocurrency can be viewed as a “share in a network”, the networks value can be directly valued as the total market capitalisation of the cryptocurrency itself, similar to the share price of a company. Added to this, the amount of transactions that are being made using the cryptocurrency can be considered it’s “earnings”. In a way, this ratio is no different to P/E ratio, which is simply market capitalisation divided by total EBITDA.

Transactions and value are both measured in $USD.

How to calculate Network Value to Transactions Ratio:

The simple method of calculating the network value to transactions ratio is to take the total network value and divide total coin market cap by the 24h transaction volume. As at 25/10/18, this would yield an NVTR of 17.75 for Ethereum. Compare this to the other major Cryptocurrencies:

BTC = 31.30

XRP = 61.85

BCH = 30.13

EOS = 14.97

(source: https://coinmarketcap.com/)

Dmitri Kalichkin (4) advocates using a 90 day moving average for NVTR, to determine a trendline. As Ethereum does not have enough data to provide a true lead indicator, time will tell whether this will be an accurate measure. It is important however to put this data front and centre.

(https://medium.com/cryptolab/https-medium-com-kalichkin-rethinking-nvt-ratio-2cf810df0ab0)

Price to Metcalfe Ratio (PMR)

The price to Metcalfe Ratio is a bit different. Though it is a much more complex ratio, it appears to be strongly correlative to indicate whether to buy or sell Ethereum.

The ratio is a logarithmic function of the daily price of the currency in USD, divided by the 30 day moving average of M2:

M2 is defined as follows:

100 X N¹.5 / S

N is representative of the total number of users on the network (which is then given the power of 1.5). The monthly active users for Ethereum cannot be truly determined, so we use the number of transactions processed on the network as a proxy. Therefore, N is the number of daily transactions, and S is the current supply of tokens (coins) in circulation.

So, for simplicity’s sake we will determine the simple PMR as being:

Ln (201/100*(537236¹.5/102803398))

= -0.64

The PMR as at 25/10/18 of -0.64, indicates a strong buy signal.

The way PMR works is that if it is positive, the network is overvalued for the number of users that are interacting with it, but if the PMR is negative, the network is being used but undervalued.

In the research (6), it is strongly implied that PMR was able to predict the major price corrections of Ethereum, as a PMR of 1 indicated a correction was looming, but a PMR of -0.25 indicated a strong buying signal as the network was undervalued and proceeded to rally.

At -0.64, the PMR of Ethereum makes it look promising.

Update: As it turns out, this was not meant to be N¹.5, but instead meant to be N². But frankly, I like N¹.5 as opposed to N² as it adds less sensitivity while maintaining the same variables, though it was a typo. Anyway, we can experiment with it and find the results.

Google Search Ratio

This is one ratio that I would never have thought of, but apparently works.

The idea that Google trends can be used as a lead indicator of Ethereum is quite novel,but makes sense when considering the number of times people use Google to search the price to USD of Ethereum, relative to the number of people who search for ways to buy Ethereum. Due to the nature of HODL, it is unlikely that people who are searching for how to buy Ethereum are existing cryptocurrency investors, but in fact new investors.

As this search ratio becomes an indicator for new buyers of cryptocurrency, or existing holders of ethereum that are intending to sell, the Google Search ratio becomes an interesting indicator for the new money that is flowing through Ethereum. This has been demonstrated to be an effective method of indicating “bubbles” (7).

The only problem with it is, Google only publishes the information for Google Search ratio with a 24 hour to 48 hour lead time.

In Willy Woo’s research (7), he indicated that Bitcoin’s bubbles could be detected by measuring the ratio between the term “Buy BTC” with “BTC USD”. The ratio seems to be a solid indicator for Bitcoin, however Ethereum may benefit more from this ratio analysis than Bitcoin.

If you look at the graph (15), over the past year, where the search term “Eth USD” was overlapped by “Buy Ethereum” (specifically on December 10th to December 17th), Ethereum seemed to start a massive run. When the term “Eth USD” then overlapped (Jan 7th), the price of Ethereum dropped massively. This might not be comprehensive, but this ratio is one of the most powerful ways to indicate if Ethereum is going down or going up. Currently, the GSR is at 25%, indicating that Ethereum is not going to move up any time soon.

Therefore, the ratio itself can be expressed as as a percentage. If Eth USD is more popular, the indicator will be expressed as less than 1. If Buy Ethereum is more popular, the ratio will be greater than 1. Usually the ratio will (hopefully) never exceed 2, so we will never see Ethereum gain too much momentum.

Though this doesn’t help our situation for trading in real time, it does give a very strong indicator for what Ethereum is doing at any point in time.

(source: https://etherscan.io/chart/tx)

Conclusion:

These 3 indicators can be considered the most important markers for Ethereum trading. If NVT is Ethereum’s P/E ratio, PMR can be considered it’s P/B ratio and GSR a lead indicator.

If these three ratios are bundled together into a trading program, or even a news site, Investors can use this information to understand when to buy and sell Ethereum (and eventually other cryptocurrencies).

Above all else, as of this moment, Ethereum could be considered undervalued.

Oscar Loudon runs the startup AssetSquared. Cryptocurrency was made for crowdfunding. We make it possible. Buy, sell and trade digital assets using the AssetSquared platform. Find out more at AssetSquared.io



Oscar Loudon

Oscar Loudon runs the startup AssetSquared. Cryptocurrency was made for crowdfunding. We make it possible. Buy, sell and trade digital assets using the AssetSquared platform. Find out more at AssetSquared.io

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