What Is Fundamental Analysis in The Context of Cryptocurrencies
If you want to know if a cryptocurrency is overvalued or undervalued, you’d have to understand and use fundamental analysis (FA).
FA involves taking a deep dive into the available information about the crypto project as a whole, like its use cases, the number of people using it, the team behind it, the technology it employs, the market conditions it operates, and so on.
By doing so, as a crypto trader or investor, you can assess the quality, viability, and sustainability of a crypto project, and compare it with others in the same niche or industry.
Read below to find out more about fundamental analysis and how it applies to cryptocurrencies.
What is Fundamental Analysis In Crypto
Fundamental analysis (FA) is a method of evaluating the intrinsic value and potential of an asset or a business by looking at various internal and external factors.
However, performing FA for cryptocurrencies is not as straightforward as for traditional assets or businesses. Cryptocurrencies are often decentralized, meaning they aren’t controlled by a single entity or authority. They also have different sources of value, like network effects, scarcity, utility, governance, innovation, and community. Therefore, crypto investors need to use different metrics and indicators to conduct FA for cryptocurrencies.
Some of the common metrics and indicators used for crypto fundamental analysis are:
- White paper
This document that outlines the objectives, technical details, and roadmap of a crypto project should provide valuable insights. It should give you clear and concise information about the problem being solved, the solution being proposed, and how the cryptocurrency will function within the ecosystem.
Crypto traders and investors, in particular, take a good look at the group of founders and developers who are responsible for creating and maintaining a crypto project. A good team should have relevant experience, expertise, and credibility in their field. It should also be transparent about their identity, background, and vision. A bad team would be anonymous, inexperienced, or untrustworthy.
Technology is the core component of a crypto project that enables its functionality and innovation. A good technology should be secure, scalable, efficient, and user-friendly. It should also be based on sound principles, like cryptography, consensus mechanisms, smart contracts, etc. A bad technology would be vulnerable, slow, costly, or complex.
- Use cases
Use cases are the practical applications and benefits of a crypto project for its users and stakeholders. A good use case should solve a real-world problem or create a new opportunity in a meaningful way. It should also have a large and growing market potential and demand. A bad use case would be irrelevant, unrealistic, or saturated.
As an example, Ethereum has a large palette of use cases, from DeFi projects to DAOs, ICOs, NFTs, stablecoins, and more.
Adoption is the measure of how widely a crypto project is used and accepted by its target audience and market. A good adoption should indicate a high level of user activity.
The rate of cryptocurrency adoption can be measured by taking into account the number of users, transaction volumes, and geographical distribution.
For instance, some reports suggest that countries like Vietnam, the Philippines, Ukraine, India, and the US are leading in crypto adoption.
- Social media sentiment
This is the measure of how positive or negative the public opinion about a cryptocurrency is, based on metrics like mentions, number of likes, comments, and followers on social media platforms such as Twitter, Reddit, Facebook, and Telegram. Social media sentiment can indicate the popularity and reputation of a coin, as well as its potential for viral marketing and word-of-mouth.
A high social media sentiment means that a coin has a loyal and enthusiastic fan base, which can increase its value and awareness.
2. Blockchain metrics
- Active addresses
Monitoring the number of active addresses on a network is a common practice to assess its usage. While not entirely foolproof (as the metric can be manipulated), it can offer insights into network activity, providing additional context for the true valuation of a particular digital asset.
- Transaction count
Transaction count serves as a reliable measure of activity within a network. By plotting these numbers over set periods or using moving averages, analysts can observe changes in activity over time. However, caution is necessary, as similar to active addresses, there’s the possibility of a single entity transferring funds between their own wallets to artificially inflate on-chain activity.
Here’s an example of blockchain metrics from Solana’s network:
- Transaction value
Distinguishing itself from transaction count, transaction value indicates the total value transacted within a specific period. For instance, if ten Ethereum transactions, each worth $50, occur on the same day, the daily transaction volume is $500. This metric can be measured in a fiat currency like USD or the protocol's native unit (ETH).
- Fees paid
The fees paid for transactions offer valuable insights, particularly for cryptocurrencies where demand for block space is critical. Similar to bids at an auction, users compete for timely transaction confirmation, with higher bids resulting in quicker confirmations. In cryptocurrencies with decreasing emission schedules, studying transaction fees becomes essential, as it directly impacts miner incentives and network security.
- Hash rate and amount staked
Hash rate serves as a crucial metric in Proof-of-Work cryptocurrencies. Changes in hash rate over time can signal shifts in mining interest; for instance, a declining hash rate may indicate "miner capitulation" as mining becomes unprofitable.
Monitoring the amount staked provides insights into user interest and participation in network validation. Both hash rate and staking data are integral components for fundamental analysis, shedding light on network security, miner behavior, and overall interest in a cryptocurrency.
3. Financial metrics
- Liquidity and volume
Liquidity serves as a gauge of how easily a cryptocurrency can be bought or sold. A crypto asset is considered liquid if it can be readily sold at its trading price. The absence of willing buyers leaves two options: adjusting the asking price or waiting for a liquidity increase.
Trading volume, an indicator of value traded within a specified timeframe, helps assess liquidity as it shows the crypto market's interest in a potential investment.
- Market capitalization
Market capitalization, or network value, represents the hypothetical cost of purchasing every available unit of the crypto asset, assuming no slippage. Market capitalization is widely used and remains a key metric for assessing the growth potential of networks.
Some investors prefer "small-cap" coins for perceived growth potential, while others believe "large-cap" coins with established network effects have a better chance of success.
- Supply mechanics
The supply mechanisms of a coin or token, like maximum supply, circulating supply, and inflation rate provide valuable insights. The supply mechanics relates to the number of coins or tokens that exist and will exist, as well as how those coins or tokens can be added or removed from circulation.
The supply of a cryptocurrency can be influenced by various factors, including mining (for proof-of-work coins), minting (for proof-of-stake coins), token burning, and more.
Coins that reduce new unit production over time may attract investors anticipating increased demand. Conversely, some investors may view a rigidly enforced supply cap as potentially detrimental, discouraging coin/token usage in favor of hoarding.
Fundamental Analysis vs Technical Analysis
Fundamental analysis evaluates the intrinsic value of an asset based on various qualitative, quantitative, and economic factors. The goal of fundamental analysis is to determine whether the asset is overvalued, undervalued, or fairly priced in the market by assessing the underlying health and performance of the asset.
Technical analysis evaluates a cryptocurrency's value based on statistics and trends of that crypto's price movements and trading volume. Technical analysis is based on the assumption that past price movements and market activity of a given asset can be used as a valuable source of information to predict its future price direction.
As opposed to FA, technical analysis doesn’t consider any fundamental factors or intrinsic value of a crypto asset. Instead, it relies on mathematical equations, charts, and graphs to identify patterns and trends that indicate either a buy or sell signal.
In short, fundamental analysis provides a deep understanding of a cryptocurrency's potential for long-term success, while technical analysis helps traders navigate short-term market fluctuations.
In practice, it’s recommended that you use a combination of both to understand the bigger picture. The recommendation is available for both short-term trades and long-term investments.
Popular Calculation Formulas in Fundamental Analysis
Check out some popular calculation formulas in fundamental analysis, shedding light on how you can use these metrics to make informed decisions in the crypto market.
I. Valuation Metrics:
Market Capitalization (Market Cap)
Formula: Market Cap = Current Price per Token * Circulating Supply
Market cap provides an overview of a cryptocurrency's total value, calculated by multiplying the current price per token by the circulating supply. It's a commonly used metric for comparing the relative size of different cryptocurrencies.
Price-to-Earnings Ratio (P/E Ratio)
Formula: P/E Ratio = Current Price per Token / Earnings per Token
Although not as directly applicable to cryptocurrencies as to traditional stocks, the P/E ratio can be adapted to assess the valuation of blockchain projects by considering factors like token utility and earnings potential.
II. Growth Metrics:
Compound Annual Growth Rate (CAGR)
Formula: CAGR = (Ending Value / Beginning Value)^(1/n) - 1
CAGR provides a smoothed annual growth rate over a specified period. It's useful for assessing the compound growth of a cryptocurrency investment.
Token Circulation Growth Rate
Formula: Token Circulation Growth Rate = ((Current Circulating Supply - Initial Circulating Supply) / Initial Circulating Supply) * 100
Evaluating the growth rate of the circulating supply helps investors understand the potential dilution of their holdings over time.
The Network Value to Transactions (NVT) Ratio
Formula: NVT Ratio = Market Cap / Transaction Volume in USD
The Network Value to Transactions (NVT) Ratio is a measure used in the cryptocurrency market that is equivalent to the Price-Earnings (P/E) ratio used in the stock market.
The result of the NVT Ratio can help you determine if the network’s market cap is justified by its transaction activity.
Fundamental analysis in the cryptocurrency market goes beyond price charts and technical indicators. It involves a comprehensive examination of the underlying factors that contribute to a cryptocurrency’s success.
By carefully considering blockchain technology, real-world applications, team dynamics, transaction value, and supply mechanics, you can gain a holistic view of a cryptocurrency's potential. As the crypto landscape continues to evolve, staying informed about these fundamental indicators becomes increasingly vital for making well-informed investment decisions.