Intrinsic value of crypto: What is it and how to calculate it

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Key takeaways

  • Cryptocurrencies like Bitcoin gain value from factors like scarcity, utility and security, not physical backing.
  • Common methods to calculate intrinsic worth of a cryptocurrency include Metcalfe’s Law, cost of production and discounted utility models.
  • Estimating intrinsic value is challenging due to market volatility and speculative data.
  • Fiat currencies have no intrinsic value, relying on trust, while cryptocurrencies’ value is based on decentralization and scarcity.

As someone who has spent countless hours delving into the world of cryptocurrencies and traditional finance, I have come to appreciate the unique qualities that set these two systems apart – their intrinsic values.

The inherent value of something refers to its true worth, determined by its essential qualities instead of its current market cost. To illustrate this in traditional finance, the intrinsic value of a stock might be calculated using factors like earnings, cash flow, and potential for growth.

“What sets this cryptocurrency apart in terms of worth beyond its market price?

The intrinsic value of cryptocurrencies is derived from factors such as:

  • Utility: What problems does cryptocurrency solve?
  • Scarcity: Is the supply limited or inflationary?
  • Network value: How large and active is the ecosystem?
  • Security: How resilient is the blockchain against attacks?
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In essence, the fundamental worth of Bitcoin (BTC) is derived from several key factors: a limited total supply of 21 million coins, a network that operates without central control, and robust security mechanisms facilitated through the process known as Proof-of-Work (PoW) mining.

Instead, it’s worth noting that a significant portion of Ethereum’s worth stems from its role as the foundation for various decentralized apps (DApps) and smart contracts.

Did you realize? According to a June 2024 report by Triple A, global cryptocurrency ownership has surged to an impressive 562 million users, marking a significant increase from 420 million in 2023. This represents approximately 6.8% of the world’s population, with Asia spearheading this growth.

How to calculate intrinsic value of cryptocurrencies: Three common methods

How about this instead: Instead of just talking theories, let’s delve into three popular techniques for calculating the true worth of a cryptocurrency.

1. Metcalfe’s Law

  • What it is: Metcalfe’s Law states that the value of a network is proportional to the square of its active users. Essentially, as more people use a network, its value grows exponentially.
  • How to apply it: This method is particularly relevant for cryptocurrencies with strong ecosystems and active users. It is calculated using the following formula:
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Example: Ethereum

Ethereum is a massive network of programmers, Decentralized Applications (DApps), and Financial Decentralization (DeFi) projects. The worth of Ethereum is strengthened by countless developers constantly contributing to its blockchain and millions of users interacting with its applications. More precisely, the count of daily active addresses can be used as a stand-in for the “size of its user base.

On December 13, 2024, as per YCharts, there are approximately 543,929 daily active Ethereum addresses in operation. Applying Metcalfe’s law to this scenario implies that the value of the network could potentially grow proportionate to the square of the number of users, or in simpler terms, the more people using Ethereum, the greater its potential worth might be due to increased interactions and transactions within the network.

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The square of the network value is approximately 296,000,000,000, which is roughly equivalent to 296 billion units. Please note that this figure does not represent a monetary value (not in US dollars).

As the number of users on a network rises, its worth tends to grow at an exponential pace. Notably, if the number of daily active addresses on Ethereum were to rise, the network’s value would likely escalate at an even more rapid speed.

Challenges

  • Oversimplification: Metcalfe’s Law doesn’t account for the quality of user interactions. A network of 1,000 inactive users is less valuable than a smaller, highly engaged network.
  • Data accuracy: Estimating the number of “active” users is tricky, especially with bots and spam accounts inflating metrics.
  • Comparative limitations: Some blockchain networks may have lower user counts but offer faster transaction speeds. Metcalfe’s Law alone doesn’t capture these differentiators.

2. Cost of production

  • What it is: This method calculates a cryptocurrency’s intrinsic value based on the cost to produce or mine it. For PoW blockchains like Bitcoin, this includes electricity, hardware and operational costs.
  • How to apply it: Production costs act as a “floor” for the cryptocurrency’s value because miners won’t continue operations if market prices fall below their expenses.

Example: Bitcoin

Bitcoin’s intrinsic value is often anchored to its mining cost.

  • As of Dec. 13, Bitcoin’s average mining cost is $86,303, while its market price was $101,523. This indicates that Bitcoin’s intrinsic value, based on mining costs, is at least $86,303. When the price exceeds this cost, mining remains profitable, incentivizing miners to secure the network. If Bitcoin’s price falls below the cost of production, miners may stop mining due to unprofitability, potentially impacting network security. The difference of $15,220 between the price and mining cost reflects a healthy market, where mining continues to be incentivized and the network remains secure.
  • During the 2022 bear market, Bitcoin’s price briefly fell to $16,000, below the production cost for some miners ($20,998). This negative difference of $4,998 meant that miners were losing money for each Bitcoin they mined. When this happens, less efficient miners may be forced to shut down, reducing the network’s hashrate and security while also causing difficulty adjustments to eventually bring costs more in line with market prices.

Challenges

  • Regional variance: Mining costs differ globally. For instance, miners in Kazakhstan or Texas benefit from cheap electricity, while those in Europe face higher costs. However, many miners are moving toward renewable energy sources, such as solar or wind power, to lower costs and become more environmentally sustainable.
  • Market volatility: Bitcoin’s price can temporarily fall below production costs, especially during market downturns.

3. Discounted utility model

  • What it is: This approach estimates a cryptocurrency’s intrinsic value by projecting its future utility, such as transaction volume or adoption, and discounting that value to the present.
  • How to apply it: Analysts evaluate potential use cases, adoption rates and transaction activity, then discount the future benefits using a specific discount rate.

Example: BNB

BNB (BNB) derives its intrinsic value from its role in the Binance ecosystem.

BNB is used to pay transaction fees, participate in token sales and access staking rewards. According to YCharts, as of Dec. 14, the BNB Smart Chain processes about 3.795 million transactions per day. Analysts can calculate the discounted value of these transaction fees over time to estimate BNB’s intrinsic worth.

Here’s how you can use the discounted utility model to estimate BNB’s intrinsic value:

Assuming the average fee per transaction is $0.10, the daily transaction fees total:

3,795,000 × 0.10 = $379,500 or 0.3795 million per day

This translates to an annual transaction fee of:

379,500 × 365 (non-leap year) = $138.52 million per year

To estimate the inherent worth of BNB in the next decade, you might consider a 10% annual rate of return. Using this discounted value equation below, the cumulative discounted worth of the anticipated transaction fees from BNB over the subsequent ten years amounts to approximately $851.13 million.

The following values represent the discounted amounts for each year, calculated using an annual transaction fee of $138.52 million and a discount rate of 10%, applied over a period of 10 years: (Note that this is a simplified explanation; actual calculations may involve complex financial formulas.)

In the given example, a hypothetical situation was utilized to explain how discounted utility models could be employed to approximate the inherent worth of BNB, considering that transaction fees remain consistent over time. Yet, it’s important to note that actual-world fees fluctuate, and factors like BNB discounts, account level, and transaction types significantly impact the precise cost.

Challenges

  • Speculative data: Estimating future transaction volumes and adoption rates involves guesswork.
  • Discount rate sensitivity: Small changes in the discount rate significantly impact the valuation.
  • Ecosystem changes: If Binance faces regulatory issues or competition, BNB’s utility might decline, invalidating earlier projections.

Why don’t fiat currencies have intrinsic value?

Fiat currency, such as the U.S. dollar or euro, doesn’t possess inherent worth in the conventional sense, unlike precious metals like gold or silver. Unlike these commodities, fiat money isn’t supported by a tangible item. Instead, its value stems from factors like government decrees, public trust, and its usefulness as a means of exchange. In academic circles, fiat money is often referred to as “an intrinsically valueless, unbacked token.

  • No tangible backing: Fiat money is not redeemable for gold, silver or any physical asset. The “gold standard” system was abandoned by most countries decades ago.
  • Value based on trust: The worth of fiat depends on people’s belief in the government’s ability to manage the economy and honor its debts. For example, the US dollar is trusted because of the economic and political stability of the United States.
  • Unlimited supply: Governments and central banks can print fiat money at will, which means its supply isn’t fixed, unlike BTC or gold. This makes fiat susceptible to inflation, which erodes its purchasing power over time.

You might be wondering how fiat currencies work. Let’s find out.

How is fiat value maintained?

Even without intrinsic value, fiat currency works because of:

  • Legal tender laws: Governments mandate using fiat currency for taxes and debts. For example, in the UK, taxes must be paid in pounds.
  • Economic utility: Fiat is highly liquid, universally accepted, and easy to use in daily transactions, making it valuable for practical purposes.
  • Backing by institutions: Central banks and financial systems create “trust” by managing fiat issuance and ensuring stability.

The debate over whether fiat or crypto has “real” value often highlights the following differences:

To clarify the difference between the two, let’s consider them from the viewpoint of definitions given in the Oxford Handbook of Value Theory (page 29). Intrinsic value refers to something that holds worth because it is valuable on its own, independent of any other factors or purposes. On the flip side, extrinsic value is attributed to something when it serves a purpose or is valuable for something else.

According to the given definitions, fiat currencies derive their value from government support and legal systems (extrinsic value), while bitcoin‘s worth comes from its unique characteristics such as scarcity (limited to 21 million units), decentralization, and functionality as a peer-to-peer network that doesn’t require trust between parties.

Unlike traditional fiat currency that depends on the trustworthiness of a central authority, Bitcoin’s value arises from its distinct, self-maintaining characteristics, which has ignited discussions about its inherent value.

Have you heard? The 2008 global financial crisis significantly undermined confidence in traditional banking. It revealed risky lending habits, faulty regulations, and the vulnerability of institutions that were previously considered ‘too big to fail.’ This erosion of trust sparked a quest for alternatives, leading ultimately to the development of Bitcoin in 2009 as a decentralized financial system without the need for trust.

Why intrinsic value matters

Comprehending inherent worth allows investors to distinguish solid ventures from those driven by speculation. In the height of the 2017 Initial Coin Offering (ICO) surge, countless tokens were introduced with minimal or no intrinsic value. Due to a lack of essential qualities – utility, security, or rarity – many failed in the long term as they couldn’t maintain consistent demand.

Instead of getting swayed by the hype, concentrating on a thing’s inherent worth can help you make wise decisions. For instance, Bitcoin stands out among others due to its robust inherent value shown through scarcity, network effects, and utility, whereas numerous other digital assets fail to maintain their relevance over time.

Ultimately, the fundamental difference between cryptocurrency and traditional money (fiat) becomes clear when you fully appreciate the distinction between intrinsic and extrinsic value, and understand how this concept relates to both.

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2024-12-16 13:45