Guide to Fundamental Analysis of Cryptocurrencies
Explained as if I were five years old
Crypto fundamental analysis is about digging deep into the information available about a financial asset. For example, you can look at the use cases, the number of people using it, or the team behind the project.
Your goal is to come to a conclusion as to whether the asset is over- or undervalued. At this point, you can incorporate your insights into your trading positions.
Trading assets as volatile as cryptocurrencies requires some skill. Choosing a strategy , understanding the wide world of trading, and mastering technical and fundamental analysis are practices that come with a learning curve.
When it comes to technical analysis, some expertise can be taken over from the old financial markets. Many crypto traders use the same technical indicators that they use when trading forex , stocks, and commodities. Tools like RSI , MACD, and Bollinger Bands attempt to predict market behaviour regardless of the asset being traded. As such, these technical analysis tools are extremely popular in the cryptocurrency space as well.
In fundamental analysis of cryptocurrencies, although the approach is similar to that used in the old markets, one cannot really use tried and tested tools for valuing crypto assets. To conduct a proper FA in cryptocurrencies, we need to understand where they get their value from.
In this article we will try to identify metrics that can be used to create your own indicators.
What is Fundamental Analysis (FA)?
Fundamental Analysis (FA) is an approach used by investors to determine the “intrinsic value” of an asset or company. By examining a number of internal and external factors, your main aim is to determine whether that asset or company is over- or undervalued. Then they can use this information to strategically enter or exit positions.
Technical analysis (TA) also provides valuable trading data, but it leads to different insights. TA users believe that they can predict future price movements based on past asset performance. It does this by identifying candlestick patterns and examining key indicators .
Traditional fundamental analysts typically use business metrics to determine what they think is real value. Indicators used include earnings per share (how much profit a company makes for each share in circulation) or price-to-book ratio (how investors rate the company against its book value). You could do this for multiple companies within a niche, for example, to find out how their likely investment compares to others.
For a more complete introduction to fundamental analysis, see What is Fundamental Analysis?
The problem of crypto fundamental analysis
Cryptocurrency networks cannot really be judged through the same lens as traditional companies. If anything, the more decentralized offers like Bitcoin (BTC) are more comparable to goods. But even with the more centralized cryptocurrencies (like those issued by organizations), traditional FA indicators can’t tell us much.
So we have to direct our attention to different framework conditions. The first step in this process is to identify meaningful metrics. By meaningful, we mean those that are not so easy to manipulate. The number of Twitter followers or Telegram / Reddit users are likely not good metrics as it’s easy to create fake accounts or buy social media engagements, for example.
It is important to note that there is no single metric that can give us a complete picture of the network we are evaluating. We could look at the number of active addresses on a blockchain and see that it has increased significantly. But that alone doesn’t say much. For all that we know, it could also be a single actor who transfers money back and forth to himself with constantly new addresses.
In the following sections we take a look at three categories of crypto FA metrics: on-chain metrics , project metrics, and financial metrics . This list will not be exhaustive, but it should provide us with a good basis for creating indicators later.
On-chain metrics are those that can be observed by looking at the data provided by the blockchain. We could do this ourselves by running a node for the desired network and then exporting the data, but it can be time consuming and expensive. Especially when we are just considering the investment and not want to waste time or resources on this endeavor.
A simpler solution would be to get the information from websites or APIs that are specifically designed to provide information for making investment decisions. The on-chain analysis of Bitcoin by CoinMarketCap, for example, provides us with a lot of information. Further sources are the data tables from Coinmetrics or the project reports from Binance Research .
Number of transactions
The number of transactions is a good measure of the activity that is going on on a network. By evaluating the number for set periods (or by using moving averages ) we can see how the activity changes over time.
Note that this metric should be treated with caution. As with active addresses, we can’t be sure that it’s not just one party transferring funds between their own wallets to inflate on-chain activity.
Not to be confused with the number of transactions, the transaction value tells us how much value was transferred within a period. For example, if a total of ten Ethereum transactions, each worth $ 50, were made on the same day, we would say the daily transaction volume was $ 500. We could measure this in a fiat currency like USD, or we could measure it in the original unit of protocol (ETH).
Active addresses are the blockchain addresses that are active in a certain period of time. Approaches to the calculation vary, but a popular method is to count both the sender and recipient of each transaction over specified time periods (e.g. days, weeks, or months). Some also examine the number of unique addresses cumulatively, that is, they keep track of the total over time.
Perhaps more importantly for some crypto assets than others, the fees paid can tell us about the demand for blockspace. We could think of them like bids at an auction: users compete with each other so that their transactions are taken into account in a timely manner. Those who bid higher will see their transactions confirmed earlier (through mining ), while those who bid lower will have to wait longer.
For cryptocurrencies with diminishing issuance plans, this is an interesting metric to study. The main proof-of-work (PoW) blockchains offer a reward called a block reward . In some it is made up of a block subsidy and transaction fees. The block subsidy decreases periodically (for events such as the so-called Bitcoin halving ).
Since the cost of mining tends to increase over time, but the block subsidy is slowly being reduced, it makes sense that transaction fees should have increased. Otherwise, the miners would work at a loss and begin leaving the network. This has a domino effect on the security of the chain.
Hash rate and the stake amount
Blockchains today use many different consensus algorithms, each with their own mechanisms. Since these play such an important role in securing the network, immersing themselves in the data around them could prove invaluable for basic analysis.
The hash rate is often used as a measure of the health of the network in proof-of-work cryptocurrencies. The higher the hash rate, the more difficult it is to carry out a successful 51% attack . However, an increase over time may also indicate a growing interest in mining, likely due to cheap overheads and higher profits. Conversely, a decrease in the hash rate indicates that miners are going offline (“surrender of the miners”) because it is no longer profitable for them to secure the network.
Factors that can affect the overall cost of the mining process include the current asset price, the number of transactions being processed, and the fees to be paid, to name a few. Of course, the direct costs of the mining process (electricity costs, computing power) are also important considerations.
Staking ( e.g. in the Proof of Stake ) is another related concept with a similar game theory as PoW mining. In terms of mechanisms, however, it works differently. The basic idea is for users to stake their own holdings to take part in block validation. So we could look at the amount used for staking at any given point in time to gauge interest (or lack of interest).
When on-chain metrics are dealing with observable blockchain data, project metrics involve a qualitative approach that takes into account factors such as the team’s performance (if any), the white paper, and the upcoming roadmap.
The white paper
It is highly recommended that you read the whitepaper for each project before investing. This is a technical document that gives us an overview of the cryptocurrency project. A good white paper should define the goals of the network and ideally give us some insight into:
- The technology used (is it open source ?)
- The use cases it is aimed at
- The roadmap for upgrades and new features
- The delivery and distribution scheme for coins or tokens
It is advisable to link this information to discussions about the project. What are other people saying about it? Are there any warning signs? Do the goals seem realistic?
With a particular team behind the cryptocurrency network, the track record of its members can show whether the team has the skills necessary to make the project a success. Have the members been involved in successful projects in this industry in the past? Is your expertise sufficient to reach the planned milestones? Were they involved in questionable projects or scams ?
If there isn’t a team, what is the developer community like? If the project has a public GitHub , check to see how many contributors there are and how much activity there are. A coin that has been constantly evolving can be more attractive than one whose repository has not been updated in two years.
A meaningful whitepaper should give us an idea of the use case that the crypto asset is targeting. At this stage, it is important to identify the projects it is competing with, as well as the old infrastructure it will be replacing.
Ideally, the fundamental analysis of them should be just as rigorous. An asset may look interesting in and of itself, but the same indicators applied to similar crypto assets could reveal weaknesses of our favorite compared to others.
Tokenomics and initial distribution
Some projects create tokens as a solution to an invented problem. While it can’t be said that the project itself would not be viable, the associated token may not be particularly useful in this context. Therefore, it is important to determine whether the token is really of any use. And, in a broader sense, whether that benefit is something the broader market recognizes and how much it would likely rate the benefit.
Another important factor to consider in this context is the initial distribution of funds. Were they made through an ICO or IEO , or could users earn them through mining ? In the former case, the white paper should set out how much will be retained for the founders and the team and how much will be available to investors. In the latter case, we could look for evidence of what is known as pre-mining (mining on the network by the founder of the asset before the project is announced).
By focusing on the distribution, we can get an idea of the risks involved . For example, if the vast majority of the offer belongs to only a few parties, we might conclude that it is a risky investment as these parties could ultimately manipulate the market.
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Information about how the asset is currently trading, what price it was previously trading at, liquidity, etc. can be useful in fundamental analysis. However, other interesting metrics that could fall into this category are those related to the economics and incentives of the protocol of the crypto-asset.
The market capitalization (or the value of the network ) is calculated by the circulating deal with the current price is multiplied. In essence, it represents the hypothetical cost of purchasing each and every available unit of the crypto asset (assuming no slippage occurs).
Market capitalization alone can be misleading. In theory, it would be easy to issue a useless token with a supply of ten million units. If only one of these tokens were trading for $ 1, then the market cap would be $ 10 million. This rating is obviously skewed – without a strong value proposition, it’s unlikely the broader market would be interested in the token.
In this context, it should be noted that it is impossible to really determine how many units are in circulation for a given cryptocurrency or token. Coins can be burned , keys can be lost and funds can simply be forgotten. What we are seeing instead are approximations trying to filter out coins that are no longer in circulation.
Nonetheless, market capitalization is used extensively to determine the growth potential of networks. Some crypto investors think it is more likely that “small-cap” coins will succeed compared to “large-cap” coins. Others believe that large caps have stronger network effects and therefore have better opportunities than non-established small caps.
Liquidity and volume
The liquidity is a measure of how easily an asset can be bought or sold. A liquid asset is an asset that we could easily sell at its trading price. A related concept is that of a liquid market , that is, a competitive market that is flooded with offers and bids (resulting in a narrower bid-ask spread ).
One problem we might run into in an illiquid market is that we are unable to sell our assets at a “fair” price. This shows us that there are no buyers willing to take the trade, so in the end we only have two options: lower the asking price or wait for liquidity to rise.
The trading volume is an indicator that can help us to determine the liquidity. It can be measured in a number of ways and is used to show how much value has been traded over a period of time. Typically, charts show the daily trading volume (expressed in native units or in dollars).
In the context of fundamental analysis, it can be helpful to be familiar with liquidity. Ultimately, it serves as an indicator of the market’s interest in a future investment.
For some, the supply mechanisms of a coin or token are among the most interesting properties from an investment perspective. In fact, models like the stock-to-flow ratio (S2F) are growing in popularity among Bitcoin proponents.
Maximum supply , circulating supply and the rate of inflation can be decisive for decisions. With some coins, the number of new units being produced is reduced over time, making them attractive to investors who believe that the demand for new units will exceed their availability.
On the other hand, other investors could rate a strictly enforced limit as harmful in the long term. Such concerns could be that there might be less incentive to use the coins / tokens as users choose to hoard them instead. Another point of criticism is that it rewards early investors disproportionately, while a steady inflation policy would be more equitable for newcomers.
Combining metrics and creating FA indicators
Now that we are familiar with some of the basic metrics, let’s talk about combining them to better understand the financial health of the assets we are dealing with. Why should you do this? Well, as we pointed out in the previous sections, every metric has flaws. Also, if you just look at a collection of numbers for any cryptocurrency project, you are overlooking a lot of important information. Consider the following scenario:
|Coin A||Coin B|
|Market capitalization||$ 100,000,000||$ 5,000,000|
|Number of transactions (6Mon)||20,000,000||40,000,000|
|Average Transaction value (6Mon)||$ 50||$ 100|
|Active addresses (6Mon)||30,000||2,000|
Viewed in isolation, active addresses don’t tell us anything significant when we compare the two offers. One could certainly say that Coin A had more active addresses than Coin B in the past six months , but that is far from a comprehensive analysis. How does this number relate to market capitalization? Or with the number of transactions?
A cautious approach would be to create some sort of ratio that we could apply to some of Coin A’s statistics , and then compare it to the same ratio that is used for Coin B’s statistics . This way we don’t blindly compare the individual metrics of each coin. Instead, we can create a standard for the independent valuation of coins.
For example, we might decide that the relationship between market capitalization and the number of transactions is much more meaningful than market capitalization alone. In this case we could divide the market capitalization by the number of transactions. For Coin A we end up with a ratio of 5, and for Coin B our ratio is 0.125.
Assuming this ratio alone, one might think that Coin B is more valuable than Coin A because the calculated number is lower. This means that the number of transactions is much higher relative to Coin B’s market capitalization . It could therefore give the impression that Coin B has greater utility or that Coin A is overrated.
None of these observations should be construed as investment advice – this is just one example of how we could paint a small piece of the bigger picture. Without understanding the goals of the projects and the function of the coins, it is not possible to determine whether the comparatively smaller number of transactions at Coin A is a positive or negative development.
A similar ratio that has gained some popularity in the cryptocurrency markets is the NVT ratio . The concept of the network value-to-transaction ratio , coined by the analyst Willy Woo, was described as the “price-to-profit ratio of the crypto world”. Put simply, it is the division of the market capitalization (or network value) by the number of transactions (usually on a daily chart).
We are just scratching the surface here as to what types of indicators can be used. Fundamental analysis is about developing a system with which projects can be assessed in all areas. The more high-quality research we do, the more data we have to process.
Done properly, fundamental analysis can provide invaluable insights into cryptocurrencies that technical analysis cannot. Being able to separate the market price from the “real” value of a network is an excellent skill to have in trading. Of course, there are things TA can tell us that FA cannot predict. For this reason, many traders these days use a combination of the two.
As with many strategies, there are no general instructions with the FA. Hopefully this article has helped you understand some of the factors to consider before entering or exiting positions with crypto assets.