Why Market Capitalization is Not the Best Metric To Evaluate Crypto?
Market capitalization can easily be manipulated. It is important to look at a wide range of different metrics.
When it comes to ranking cryptocurrencies, market capitalization has been the main method since altcoins first appeared in 2011. This method of looking at digital assets was primarily propagated by CoinMarketCap, which quickly arose to become the go-to cryptocurrency market data provider in the early days of the fast-growing cryptocurrency market.
Today, there are a wide range of crypto asset market analytics providers but most of them still use market capitalization as their main ranking factor for crypto assets. However, many experts agree that this is not the best way to look at cryptocurrencies as this metric can be misleading and does not best determine a cryptocurrency’s value.
Market Capitalization and its Limitations
Market capitalization is often referred to as the value of a cryptocurrency. For example, you will read that bitcoin is currently worth USD 124 billion. That number is calculated by the number of bitcoin in circulation multiplied by the price per coin. This metric originally comes from the stock market, where it is used as a measure to gage the value of publicly-traded companies.
However, in the cryptocurrency space, market capitalization as a measure of value has its limitations.
Market capitalization can be easily manipulated as pointed out by PhD researcher, Mustafa Al-Bassam, at University College of London who pointed out in a tweet that “someone bought 0.002 of the cryptocoin "FirstBlood", for $140 of Ether, causing the market price to be shown at $69,000 a coin, a 100,000% increase, making the market cap $163B, making it the second biggest cryptocoin.” In other words, price as well as market capitalization can easily be manipulated by off-market trades and, hence, are a poor value metric for cryptocurrencies.
Moreover, as pointed out by Nvidia, an American technology company, software engineer John Ratcliff in a tweet, if you were to create an altcoin with a total token supply of one trillion and then sell one token to another party for one dollar, you would then have the biggest cryptocurrency in the market with a market capitalization of USD 1 trillion.
Market capitalization, therefore, creates a false sense of value for cryptocurrencies. That is especially true for those where many of the coins are still held by the founding team as highlighted by Zach Herbert, Vice President of Operations at Sia, a decentralized storage platform, in a blog post.
Herbert argues that market cap calculations should not be conducted using circulating token supply and should instead incorporate the total token supply as is the case in market capitalization calculations for stocks. The market cap in the stock market incorporates shares in circulation and those held by the company. This is referred to as shares outstanding. If this would be applied to the cryptocurrency markets, market cap valuations would drop substantially for many of the leading digital assets in the market.
Herbert also points out that inflation plays a major role in crypto asset evaluation as it partly dictates the future value of digital tokens. Tokens with slow inflation rates find it easy to preserve or increase their value over time whereas those with high inflation rates should - in theory - see their value decrease over time.
“In the token world, we have the wonderful benefit of codified inflation rates. This allows us to estimate the inflation over time for most tokens, and therefore estimate the future market cap. However, sites and exchanges are not properly conveying this information to investors, and therefore the majority of investors are likely not factoring this into their valuations,” Herbert argues.
To combat this issue and to better evaluate future cryptocurrency values, he suggests that analytics sites and exchanges should add an inflation factor, which he calculates as follows: Inflation factor = (new supply over 5 years) / (current total supply) * 100%. This metric shows the percentage increase of a coin’s circulating token supply.
By utilizing the total token supply to calculate market capitalizations and by adding the inflation factor metric to cryptocurrency evaluations, Herbert believes that investors can view a more accurate image of future crypto asset valuations.
What Could Be Better Metrics?
Incorporating the total token supply into the market capitalization calculation and adding token inflation into account, would give investors a better view of the current as well as the future value of a cryptocurrency. However, there are also other metrics that should be taken in consideration that may offer more insight into how a crypto asset is performing.
Chris Burniske, author of the book ‘Crypto Assets: The Innovative Investor's Guide to Bitcoin and Beyond’ and a partner at Placeholder, a New York venture firm that specializes in cryptoassets, sparked a discussion on Twitter at the beginning of the year when he tweeted the question: “What are the best metrics you use to assess *fundamentals* around #cryptonetwork health?”
Responding users recommended metrics such as level of decentralization, number and growth rate of active participants/participating nodes, and developer activity as fundamentals that need to be looked at.
Ragnar Lifthrasir, blockchain entrepreneur and CEO of velox.RE, a real estate focused blockchain company, stated in a separate tweet that he would like to see metrics such as “anti-fragility, censorship resistance, developer community quality / quantity, total losses from software exploits (e.g. The DAO, Parity wallet), and usability for [the] average person” to be used to evaluate digital assets.
These are arguably very important aspects of a cryptocurrency network, which are rarely taken into consideration by analytics providers in this space. After all, how valuable is a cryptocurrency project if it is too centralized to be truly censorship resistant? Or, how much value does a cryptocurrency really have when no one is actually using it (yet)?
What Metrics Should You Use?
When it comes to evaluating crypto assets for investment purposes, it is important to look at a wide range of different metrics. Preferably, all of those mentioned above. That way you are able to receive an in-depth look into a cryptocurrency and are able to compare it with others in the same market segment to see if the token you like is over or undervalued compared to its peers.
Incorporating “true” market cap (which uses the total token supply), the inflation factor, the size and quality of a cryptocurrency’s team, the current usability of the token, the amount of active users and holders of the token, the security track record of the project, and the level of censorship resistance into your model would be a good start to receive a better image of how much the token you are looking into investing is currently worth and how much it may be worth in the future.