A Guide to Fundamental Analysis of Cryptocurrencies
Analyzing volatile assets like cryptocurrencies requires special skills and knowledge. It involves choosing a strategy, understanding the complex world of trading, and combining both technical and fundamental analysis, which is essential for successful exploration of this field.
As for technical analysis, some of its concepts are similar to traditional financial markets. Many cryptocurrency traders use familiar technical indicators, such as RSI, MACD, and Bollinger Bands, to analyze the cryptocurrency market, as these tools are suitable for studying market behavior regardless of the traded asset. Thus, these popular technical analysis tools are widely used in the cryptocurrency space.
In the case of fundamental analysis of cryptocurrencies, the approach can be similar, but established tools used in traditional markets may not always be applicable. To objectively evaluate crypto assets based on fundamental parameters, one needs to understand the sources and mechanisms that give them value.
In this article, we will present key indicators that will allow you to develop your own fundamental indicators for cryptocurrency analysis.
What is Fundamental Analysis (FA)?
Fundamental analysis (FA) is a technique utilized by investors to assess the "intrinsic worth" of an asset or a business. Its primary aim is to scrutinize various internal and external elements to determine if an asset or business is overvalued or undervalued. This information forms the basis for making strategic decisions about entering or exiting investment positions.
While technical analysis also provides valuable trading data, its purpose is to draw different types of conclusions. Technical analysts and market participants using this approach aim to predict future price changes by analyzing the historical performance of assets. This is accomplished by studying candlestick patterns and examining key indicators.
To determine the actual value of assets, traditional fundamental analysts frequently rely on business metrics. Popular indicators include earnings per share (which calculates the profit generated per issued share by a company) and the price-to-book ratio (enabling investors to assess a company relative to its book value). Fundamental analysts often apply this analysis to several companies within the same industry to assess how their potential investments compare to those of other investors.
Challenges of Cryptocurrency Fundamental Analysis
Cryptocurrency networks cannot be evaluated using tools employed in traditional businesses. Even more centralized cryptocurrencies issued by organizations remain complex to analyze using conventional fundamental analysis indicators. Decentralized systems like Bitcoin (BTC), for instance, bear a closer resemblance to the commodities sector, making the assessment of their value a more challenging task.
Hence, it's essential to explore alternative methods and frameworks. Identifying "reliable" metrics that are hard to manipulate is crucial. For example, the number of Twitter followers or Telegram/Reddit users can be a questionable indicator as it's easy to create fake accounts and manipulate social media activity.
It's important to understand that there isn't a one-size-fits-all metric that can comprehensively assess the value of a cryptocurrency network. While one might pay attention to a sharp increase in the number of active addresses on the blockchain, it doesn't provide a complete picture by itself. For instance, behind a large number of addresses could be the same entity conducting transactions between new addresses.
In the following sections, we will delve into three categories of indicators used in cryptocurrency fundamental analysis: on-chain metrics, project data, and financial metrics. This list is not exhaustive but provides sufficient information to create your own indicators.
On-chain metrics are characteristics that can be extracted from blockchain data. While theoretically, one could obtain this data by running their own node in the network of interest and exporting the information, this process can be time-consuming and costly, especially if one is solely interested in investment and does not wish to expend resources on technical details.
The simplest solution is to gather information from websites or APIs specifically designed to provide the necessary data for making investment decisions.
Number of transactions
The number of transactions is a good indicator of network activity. Plotting a chart for specific time periods (or using moving averages) allows for tracking changes in activity over time.
However, it's essential to note that this metric should be interpreted with caution. Just like with active addresses, it's possible that network activity is generated by a small number of participants who are making transfers among themselves.
Unlike the number of transactions, the transaction value shows the total transaction volume over a specific period. For example, if ten Ethereum transactions worth $50 each were made within one day, the total transaction value for the day would be $500. This metric can be measured in both fiat currency, such as USD, and the native protocol token (ETH).
Active addresses are addresses in the blockchain that exhibit activity within a specific time period. There are several methods to count active addresses, but the most common approach considers addresses as both senders and receivers in each transaction over a defined period (e.g., a day, week, or month). Additionally, you can analyze the total number of unique addresses, allowing you to track the overall count of active addresses over time.
Commissions, or fees, are the costs users of the blockchain pay for including their transactions in a block. They can be thought of as bids in an auction, where users compete with each other for the opportunity to have their transactions confirmed quickly in the blockchain. Transactions with higher fees will be processed (mined) faster, while transactions with lower fees may take more time to be confirmed.
For cryptocurrencies that have a gradual reduction in supply (e.g., Bitcoin), fees become an interesting metric for analysis. In Proof of Work (PoW) consensus mechanism networks, miners receive rewards for creating new blocks. This reward includes the block reward as well as fees from users for processing their transactions. As the block reward decreases over time (e.g., due to Bitcoin halving), the growth of transaction fees becomes an important aspect. If fees remain low, miners may face losses and leave the network, negatively impacting its security.
Hashrate and Staking Coin Amount
Hashrate (for Proof of Work networks): Hashrate is a measure of computational power directed towards mining and securing the network. Blockchains using the Proof of Work (PoW) mechanism have a high hashrate, making 51% attacks more challenging. An increase in hashrate can indicate growing interest in mining, especially if the asset is profitable. A decrease in hashrate may signal miners leaving, which can threaten network security.
Amount of coins staked (for Proof of Stake networks): In networks using the Proof of Stake (PoS) mechanism, users lock up their coins for participation in block validation. The amount of coins staked can serve as an indicator of interest in the network. If more coins are staked, it can signify trust in the network. It can also affect staking rewards and rates.
Both of these metrics can provide insights into the health and interest in a specific cryptocurrency, but their significance varies depending on the consensus mechanism used in the network.
While blockchain metrics relate to data analyzed within a blockchain project, project development metrics involve considering qualitative aspects such as team efficiency (if it exists), whitepaper content, and the development roadmap.
Before investing in any project, it is strongly recommended to review its technical document known as a whitepaper. This document serves as an overview of a cryptocurrency project, and a good whitepaper should include the following key elements:
Description of the technology used (including access to the source code).
Project development prospects and potential use cases.
A detailed roadmap specifying planned updates and new features.
Information on how the project's coins or tokens will be distributed.
These details should be analyzed in the context of project discussions, and it's also important to consider the opinions of other investors. Pay attention to potential red flags and the feasibility of the set goals.
The team plays a significant role in evaluating a cryptocurrency project. Examining the history and experience of team members can provide insight into their abilities to execute the project. Have team members been involved in successful cryptocurrency and blockchain projects before? Is their experience sufficient to achieve the project's goals, and have they been associated with questionable projects or fraudulent activities?
If there is no team, then it's worth paying attention to developers in the community. If the project has a GitHub page, check the number of contributors and their activity. A coin that is constantly worked on by developers and regularly updated may be more attractive than a project whose repository has not been updated for two years.
A good technical document (whitepaper) should provide an understanding of the use case the cryptocurrency asset aims to address. At this stage, it's important to identify the projects it competes with and the existing infrastructure it plans to replace.
Ideally, conducting fundamental analysis of competing projects is an important step. Even if the asset itself looks attractive, comparing its characteristics with similar cryptocurrencies may reveal that it is less competitive.
Tokenomics and Initial Distribution
Tokenomics and the initial distribution are of great importance when assessing a cryptocurrency project. Some projects create tokens but face issues related to their utility. It's essential to understand how useful the token is and whether it's widely accepted by the market. Additionally, if the token provides any utility, its evaluation among participants is crucial.
Another critical factor is the method of the initial token distribution. This can be done through ICOs, IEOs, or mining. In the case of an ICO, the whitepaper should provide information about the allocations for founders, the team, and tokens available to investors. In the case of mining before the official project launch, it's worth examining how the pre-mining is organized (mining of tokens before the public launch).
Analyzing the initial distribution can provide insights into potential risks. For example, if a large portion of tokens is held by a small group of individuals, this can pose a risk as these individuals may manipulate the market.
Fundamental analysis encompasses various aspects, including information about the current and historical trading methods of the asset, its liquidity, and other related factors. However, in this category, there are also other interesting metrics related to the economics and incentives of the cryptocurrency asset's protocol.
Market capitalization, also known as network value, is a metric calculated by multiplying the quantity of cryptocurrency assets in circulation by the current price of each unit of the asset. In essence, it provides an estimate of the total expenditure required to acquire all available units of a particular cryptocurrency (assuming no slippage occurs).
However, relying solely on market capitalization can be deceptive. Theoretically, it's possible to create a valueless token with an extensive supply. For example, if each unit of the token is valued at $1, the market capitalization would be $10 million. Nevertheless, this doesn't indicate genuine market interest in a token lacking a value proposition.
Furthermore, accurately determining the exact number of a specific cryptocurrency or token in circulation is often challenging. Coins may become lost, keys can be misplaced, and some assets may be forgotten. Hence, approximations are generally employed, accounting for the number of coins that may be inaccessible.
Nevertheless, market capitalization is widely employed to assess network potential. Some cryptocurrency investors believe that coins with a low market capitalization offer greater growth potential compared to those with a high market capitalization. Conversely, others contend that a larger market capitalization establishes a more robust network effect and, as a result, greater prospects for success compared to coins with a low market capitalization.
Liquidity and Volume
Liquidity and trading volume are essential factors to consider when evaluating a cryptocurrency. Liquidity measures the unique characteristic of how easily you can buy or sell an asset at its current market price, and a liquid asset is one that possesses the unique quality of being quickly tradable without significant price fluctuations. This concept is closely linked to the unique idea of a liquid market, where there is a high level of unique buying and selling activity, resulting in a narrow spread between buying and selling prices.
In contrast, an illiquid market poses unique challenges because it may be hard to sell an asset at a fair price, often due to a unique absence of interested buyers. In such cases, investors may need to lower the selling price or wait for unique, more favorable market conditions.
Trading volume is a crucial metric for assessing liquidity, and it quantifies the value of assets traded within a specified time period, typically on a daily basis. It's a unique measure that can be expressed in either the asset's units or in terms of dollars.
Understanding the unique aspect of liquidity is vital for fundamental analysis, as it indicates how attractive an asset is to potential investors in the market.
Distribution schemes are one of the key characteristics that pique the interest of investors when making investment decisions. There are various distribution models, and one of the popular schemes among Bitcoin investors is the Stock-to-Flow (S2F) model.
Stock-to-Flow (S2F) relies on characteristics such as maximum supply, current circulating supply, and inflation. The core idea is that as the production of new coins decreases over time, the asset becomes more attractive to investors. They anticipate that demand for new units of the cryptocurrency will outstrip their availability, potentially driving price appreciation.
However, there are also arguments against deflationary models, including S2F. Some investors fear that a strictly limited maximum supply may hinder the asset's utility in the future, as users might prefer hoarding it rather than spending. Another counterargument against deflationary models is that they may unfairly reward early adopters, whereas a more stable inflationary policy could be fairer to new users.
Thus, coin or token distribution schemes can have various impacts on the long-term dynamics and utility of an asset, and investors typically conduct a thorough analysis of these aspects before making investment decisions.
Indicators, Metrics, and Tools of Fundamental Analysis
Fundamental analysis encompasses a plethora of metrics, indicators, and tools that help investors and analysts understand cryptocurrency assets. It is crucial to analyze their interrelationships and employ tools to streamline this process.
Indicators are tools that combine multiple metrics through statistical formulas to simplify the analysis of relationships. They allow for deeper insights based on available data. Examples of indicators might include the percentage of active wallets out of the total number of wallets or the average asset value in active wallets. These indicators provide insight into network activity and user trust in the asset.
Fundamental analysis tools facilitate the collection and analysis of all available metrics and indicators. They enable the efficient and rapid analysis of data. Some tools also allow the creation of custom indicators using selected metrics.
Combining metrics into indicators and utilizing analysis tools helps investors make informed decisions about cryptocurrency assets and understand their fundamental characteristics.
Combining Metrics and Creating FA Indicators
Combining metrics and creating indicators in fundamental analysis is a crucial way to gain a deeper understanding of the financial health of assets. Individual metrics may not provide a complete picture, and it's important to consider them in the context of other factors.
Imagine we have two assets, and one of them has a higher number of active addresses than the other. But this number alone doesn't tell us about the asset's value. For a more comprehensive assessment, we can create an indicator that combines several metrics, such as the ratio of market capitalization to the number of transactions. Such an indicator allows us to compare assets more reliably.
One such indicator is the NVT ratio, which evaluates the relationship between market capitalization and transaction volume. This approach enables a deeper analysis of assets and an assessment of their value.
It's important to note that fundamental analysis is a complex process that requires gathering a substantial amount of data and creating indicators for a comprehensive evaluation of projects. This helps avoid superficial analyses and make more informed decisions.
Key FA Indicators and Metrics
When engaging in fundamental analysis, there are numerous indicators and metrics to study. If you're just starting to explore this field, it can be helpful to begin with the most popular and key indicators. Each of them provides only a partial view of the asset's condition, so it's recommended to combine different indicators in the analysis process to obtain a more complete picture.
Network Value to Transaction Volume (NVT) Ratio
The Network Value to Transactions Ratio (NVT) is the cryptocurrency counterpart of the P/E (Price-to-Earnings) ratio used in stock analysis. To calculate it, you need to divide the market capitalization of a coin by the daily transaction volume in that network.
This indicator assesses how actively a cryptocurrency network is being used. If the market capitalization is significantly increasing but the daily transaction volume remains low, it may indicate the formation of a market bubble. This means that asset prices are rising without a corresponding increase in real network activity. On the other hand, if the cryptocurrency's price remains stable but the transaction volume is increasing, it may signal investment opportunities.
A NVT ratio above 90-95 can indicate overvaluation of the asset and the potential for a bubble. A decrease in the NVT value may suggest that the asset is becoming less overvalued.
Market to Realized Value Ratio (MVRV)
The Market Value to Realized Value (MVRV) ratio is a metric that evaluates the relationship between the current market capitalization of a cryptocurrency and its realized value. To grasp this indicator, it's essential to differentiate between two fundamental concepts:
Market Value (or Market Capitalization): This figure represents the total number of coins in circulation multiplied by the prevailing market price of the cryptocurrency. It serves as an estimate of the entire value of the cryptocurrency network based on its present prices.
Realized Value: This metric accounts for coins that might have been lost or forgotten in inaccessible wallets. It's calculated by assessing coins according to their price at the time of their last recorded activity.
The MVRV indicator is determined by dividing the market capitalization by the realized value. A high MVRV value (typically above 3.7) can indicate potential overvaluation of the asset, potentially prompting traders to sell for profit. High MVRV values, as seen in 2014 and 2018, were associated with significant sell-offs in Bitcoin.
Conversely, if the MVRV value falls below 1, it may suggest that the asset is undervalued, offering investment opportunities. A low MVRV value can stimulate increased demand and, consequently, drive up the asset's price.
The MVRV indicator aids in evaluating the cryptocurrency's relative overvaluation or undervaluation based on the difference between its current market value and realized value.
The Stock-to-Flow (S2F) indicator is a popular tool for assessing cryptocurrencies with a limited supply. This model views a cryptocurrency as a scarce and finite resource, akin to precious metals and other long-term assets. Since the supply of the asset is limited, and there is no possibility to create new sources, investors use it as a store of value and investment.
The calculation of the Stock-to-Flow indicator is performed by dividing the total supply of the asset in circulation by the amount of new coins entering circulation over a specified period, usually a year. For Bitcoin, for example, this indicator can be easily calculated using data on the current Bitcoin supply and the number of new Bitcoins created through mining in a year.
The reduction in the Bitcoin mining reward, often referred to as "halving" (when the reward is halved), increases the value of the Stock-to-Flow coefficient. This reflects an increase in the scarcity of the asset and makes it more valuable. The chart of this coefficient and the price of Bitcoin demonstrates a strong correlation.
However, the Stock-to-Flow model has its limitations. One of them is that it is not suitable for assessing assets during deflationary periods because it assumes a negative price. In cases where people lose access to their wallet keys, and the production of new coins stops, the Stock-to-Flow ratio can become negative. Graphically, this would be represented as the coefficient trending towards infinity and then towards a negative value.
Furthermore, when using the Stock-to-Flow model, it's important to remember that it assumes a continuous increase in the price and market capitalization of the cryptocurrency in the future. This doesn't always align with real market conditions and can be a subject of debate among economists and analysts.
Examples of tools for fundamental analysis
Baserank is an example of a tool for fundamental cryptocurrency analysis. This tool provides information and reviews from analysts and investors, and it assigns an overall score to cryptocurrencies based on the average ratings of all reviews. The overall score can range from 0 to 100, offering a summarized evaluation of the cryptocurrency.
Baserank also provides premium reviews to its subscribers and offers comprehensive free reviews categorized into sections such as team, utility, and investment risk. This is convenient for investors seeking a quick overview of a project or cryptocurrency.
However, it's important to remember that fundamental analysis requires a deeper dive into projects and coins. Baserank can serve as a useful starting point, but it's always recommended to conduct your own research and analysis, especially when making investment decisions.
Crypto Fees is a resource that provides information about blockchain network fees for the last 24 hours or the past seven days. This metric can be useful for analyzing the activity and usage of blockchain networks. Networks with high fees usually indicate a high demand for their services.
However, it's essential to understand that fees can vary depending on the network, and they can't always be directly compared. Some blockchains are designed with low fees in mind, and comparing them to networks with higher fees might not be entirely fair. In such cases, besides fees, other metrics like the number of transactions and market capitalization should also be considered. For example, cryptocurrencies with large market capitalization, such as Dogecoin and Cardano, may have low transaction fees and rank low in overall fee rankings.
Glassnode Studio is a platform that offers a comprehensive set of data and metrics for analyzing cryptocurrencies and their blockchains. This tool provides information about various on-chain metrics and other data. It is available through a subscription, but it also provides free data that can be valuable for amateur investors.
The main advantage of Glassnode Studio is its extensive collection of categories and subcategories of metrics, making it a valuable resource for analyzing cryptocurrency projects. This tool also offers the ability to integrate fundamental analysis metrics with technical analysis, providing a TradingView interface with charting tools for price and volume analysis.
By using Glassnode Studio, investors and traders can combine fundamental analysis data with technical analysis to make informed decisions about their investments. This tool provides the opportunity to gather all the necessary information in one place, which can significantly streamline the analytical process.
Fundamental analysis can offer valuable insights into the world of cryptocurrencies and assist investors and traders in gaining a deeper understanding of their potential. This analytical approach aids in distinguishing market prices from the "intrinsic" value of blockchain networks and serves as a valuable instrument for guiding trading and investment choices. Nonetheless, it is crucial to recognize that fundamental analysis doesn't adhere to strict, universal principles, and every investor can formulate their own strategies rooted in this approach. Such analysis might involve assessing a project's team, technology, market dynamics, competitive landscape, and other variables. Ultimately, fundamental analysis remains a potent instrument for scrutinizing cryptocurrency projects and making informed decisions, though its effectiveness hinges on meticulous research and adaptability to particular market conditions.