In this article, we'll explore how analysts evaluate cryptocurrency projects using fundamental analysis, an approach that identifies strong and prospective assets by researching and analyzing their quantitative and qualitative metrics. This method is grounded in the belief that these factors will translate into future profits.
What is Fundamental Analysis?
If you're interested in finance, you've likely encountered fundamental and technical analysis. In this article, we'll focus on fundamental analysis to evaluate crypto projects, which we believe is the ideal option for long-term investments.
Fundamental analysis helps investors determine an asset's intrinsic value, aiming to buy the asset when it's undervalued and sell it when it's overvalued, as illustrated in the image below.
Crypto vs Equity Research
Cryptocurrency analysis differs from equity analysis because there are no financial statements. Investment professionals commonly evaluate companies using discounted cash flow (DCF), a method that estimates a company's value by bringing possible future cash flows to present value. Crypto projects lack the data for this approach, but alternative metrics can offer insight for evaluating projects and selecting the most promising ones.
The crypto market encompasses various sectors that don't always require the same metrics or fundamentals. For instance, Bitcoin shares more similarities with commodities than stocks. In contrast, Decentralized Finance (DeFi) projects present metrics akin to tech and financial companies, making them a completely different study compared to Bitcoin, even though both belong to the crypto market.
With that in mind, we'll present the main fundamental metrics for evaluating cryptocurrencies from a general perspective.
Since we cannot analyze financial statements for Bitcoin or Ethereum and make predictions of future cash flows (as they are not companies), we need an alternative method for evaluating projects and identifying undervalued assets.
Comparing metrics between various crypto projects within the same sector can reveal differences in their market performance.
For example, if you study a project and discover that the team behind it is experienced, has attracted investments from VCs, demonstrates strong on-chain metrics, and features innovative technology, but is valued lower in the market than another project in the same sector that you judge to be inferior, it could be undervalued and represent a buying opportunity.
This metric is subjective and relies on evaluating whether a project makes sense, whether the team behind it is competent and dedicated to delivering the best user experience, how it differs from competitors, its roadmap, and more.
Project Value proposition
This metric is critical for avoiding meme and nonsensical projects that offer little or no value to users.
Value proposition entails understanding what the project provides to users and how it addresses their needs. For example, Bitcoin offers a decentralized system that allows users to store, send, and receive money without relying on an intermediary. Ethereum enables the creation of smart contracts on its network, which attracts developers to the platform.
In short, this should be the first aspect you examine when studying a project. You can find information about how the project works, its technical details, and its objectives in the whitepaper.
The team behind a project is a crucial factor in the analysis and is often underestimated. Some key questions to guide your team analysis include:
- What is the team's track record in the industry?
- Have they received investments from reputable venture capital firms?
- What is their experience?
- What is their stance on blockchain technology, and are they committed to it for the long run?
- Has anyone on the team been previously involved in a scam project?
Satisfactory answers generally indicate that the project team is competent and serious about building a valuable application.
A project's community is vital for understanding its success. A robust community of developers and users signals an active ecosystem, which can be a positive indicator of the project's future growth.
Consider Bitcoin as an example. While it may not be the most technologically advanced or efficient blockchain in the crypto market, it holds the number one position in terms of market capitalization. This is despite numerous developers attempting to create improved versions of the blockchain over the years.
Another excellent example is Uber. While anyone with sufficient funds can hire a development team and create a similar app to enhance the transportation experience, the likelihood of success is slim. In the case of companies like Uber, the most valuable asset they possess is neither physical nor technological; instead, it is the network of people who use and provide the service.
Evaluating competitors is essential for crypto, stocks, corporate bonds, and virtually every other asset class.
A crypto project might be well-designed and have solid metrics, but if its competitors hold a significant market share and remain unchallenged, it could represent a poor investment, particularly in the long run.
Tokenomics is a term that describes the economic model of a project's token. It explains how supply and demand function within the ecosystem, as well as the issuance of new tokens and their distribution to investors, developers, early contributors, and other participants.
Understanding tokenomics is crucial as it can significantly impact an investment decision.
Numerous crypto projects offer impressive technology, boast a talented team, have an active community, and present compelling use cases that address various issues. However, their tokens may not adequately capture the value of these positive aspects.
Projects with excellent fundamentals but poor tokenomics may experience short-term hype and impressive gains, only for investors and users to later realize the token lacks utility, which leads to selling and a subsequent price drop.
On-chain metrics are measurements derived from data provided by the blockchain, including:
The hash rate measures the computation power or mining difficulty in a Proof-of-Work (PoW) blockchain, like Bitcoin.
A higher hash rate indicates a more secure network, as it reduces the likelihood of a malicious validator successfully executing a 51% attack. An increase in hash rate signifies growing interest in mining activity, attracting more participants and investment.
A low hash rate reveals a lack of interest in mining, which may stem from:
- Expensive mining costs (electricity and hardware).
- Poor performance of the blockchain's native currency.
- Changes in validator fees.
Staking activity serves to validate transactions and secure a Proof-of-Stake (PoS) blockchain. It is conceptually similar to the hash rate but utilizes a different metric.
An increase in the staking amount indicates interest in the network and enhances its security. Conversely, a decrease in staking can signal disinterest in the project and reduced network security.
Number of Transactions
This metric reflects the blockchain's activity. Generally, a higher number of transactions suggests increased user engagement and a higher demand for the native token, potentially driving up its price.
It's worth noting that a larger number of transactions doesn't necessarily equate to greater interest in the project. On-chain transactions may involve two different individuals or a single person using multiple wallets.
Nonetheless, this metric can help gauge a network's growth in activity, as the chart below shows.
Transaction fees are crucial as they incentivize validators to secure a blockchain. High network demand leads to increased fees, attracting more validators and bolstering blockchain security.
Fees increase during periods of heightened activity, as users who pay higher fees get their transactions validated first, essentially functioning like an auction bid.
This metric, frequently employed by analysts, reveals the number of wallets interacting with the blockchain or a protocol within a specific time frame.
While the number of transactions could be inflated due to multiple wallets belonging to one person, it remains a valuable metric for evaluating a project's social activity.
Financial metrics provide insights into a crypto asset from a market perspective, which is crucial knowledge before investing in a crypto project.
Market capitalization is calculated by multiplying the circulating supply by the asset's current price.
Although the metric itself offers limited information, it is essential for comparing crypto assets and making growth projections for a project.
If Project A's token is worth $5 and Project B's token is worth $10, the latter isn't necessarily a larger project. The price of each token must be multiplied by their respective circulating supplies for accurate comparisons.
Supply information can significantly influence investment decisions. For example, Bitcoin (BTC) has a maximum supply of 21 million, meaning no more BTC will be mined once this limit is reached. This scarcity is why many consider Bitcoin a form of digital gold and a non-inflationary store of value.
Many projects don't have a maximum supply and are inherently inflationary. It's essential to understand this concept because of the supply and demand rule: If there are more tokens or coins in circulation, their value will decrease if all other factors remain constant.
Therefore, when investing in a promising project with an inflationary policy, it's crucial to put your crypto assets to work and earn interest on them. Otherwise, your investment may lose value over time.
Liquidity is typically not an issue for retail investors when considering top crypto assets. However, when investing in a lesser-known project, it's an essential factor to bear in mind.
Liquidity reflects the ease with which an asset can be bought or sold, considering the trading volume in the market. Consequently, a low-liquidity asset is harder to sell. If the asset quantity exceeds market liquidity, the asset may need to be sold at a lower price.
The previously mentioned metrics are general, making them useful for most projects. However, other metrics are more relevant to specific sectors, such as the following for DeFi:
- Total Value Locked (TVL): Measures the total amount of assets deposited in a protocol.
- Revenue: Typically derived from the fees users pay for transactions within the application.
- Token Incentives: Tokens distributed to incentivize users. In DeFi, this usually refers to the value paid to liquidity providers. On blockchains like BTC and ETH, this is the value paid for validating transactions and maintaining network security.
- Earnings: Revenue minus token incentives.
Some DeFi protocols already use earnings to benefit token holders through dividends or buy-backs.
Uniswap, for example, does not generate profit since 100% of the fees paid go to liquidity providers. However, this could change because Uniswap is a Decentralized Autonomous Organization (DAO) where token holders can vote to alter the protocol's operation.
- Price to Fees ratio (P/F): A metric that indicates how a project is valued relative to its fees. A lower P/F ratio generally signifies a better investment, as it could imply an undervalued project.
- Market Cap/TVL: A protocol with high TVL and low market cap could be undervalued. A lower metric usually indicates a better investment opportunity.
Crypto Correlation with Traditional Markets and Macroeconomics
Cryptocurrencies were once considered uncorrelated assets to traditional markets that investors and hedge funds could use for portfolio diversification. However, this narrative has shifted in recent years.
As the chart demonstrates, Bitcoin has displayed a high correlation (near 1) with the S&P 500 and NASDAQ for most of the presented time, challenging the previous diversification rationale.
One explanation for this change is the increasing consolidation and interest in the market from major firms, investors, and retail traders. Although the crypto market capitalization remains significantly lower than traditional markets, its growth continues to attract new participants.
Stocks and other traditional markets are susceptible to monetary policy events, and the crypto market has become similarly vulnerable, particularly in 2022, amid high inflation and economic tightening.
To combat rising inflation, central banks worldwide increased interest rates to slow economic activity. Higher interest rates make loans and credit services more costly for individuals and businesses, resulting in reduced spending and investment compared to periods of low-interest rates.
In turn, reduced profits for companies lead to job cuts, setting off a snowball effect of increased unemployment and decreased inflation.
During periods of economic tightening, risk assets like stocks and cryptocurrencies tend to suffer, as investors seek to protect their capital with lower-risk investments offering higher interest, such as government bonds.
It is worth noting that the impact of macroeconomic events on cryptocurrencies is a recent phenomenon. Some analysts believe the correlation with traditional markets is temporary and that cryptocurrencies will eventually be driven by entirely different factors. Only time will tell, but the existing data indicates that this correlation is real and may persist for the foreseeable future.
This article provides an overview of how to analyze crypto projects based on their fundamentals and potential future growth.
Due to its smaller size, the crypto market is highly volatile, which can lead to short-term irrational movements that don't align with an asset's fundamentals. However, we believe that well-founded projects with strong tokenomics are more likely to perform well in the long run and withstand market crises better than others.
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