Cryptocurrency investment has been almost entirely speculative. In 2017, anyone with a half-baked idea could write a whitepaper, create a token contract, and raise $50 million in a week-long ICO.

Besides Joe and Jane Sixpack, participants with larger allocations were BTC early adopters and Silicon Valley veterans who should have known better. Then again, everyone is a genius in a bull market.

It wasn’t until the bear market struck that these investors started second guessing their positions. Fundamentally, investors failed to understand that cryptocurrencies (and tokens) should be valued not as stocks or commodities but as currencies.

Fortunately, it’s not only possible to value cryptocurrencies on a fundamental basis, this type of appraisal delivers more accurate valuations than speculative targets, and fortune awaits those who identify these investment opportunities.

The Equation of Exchange

The equation of exchange is used by economists to model currencies. It has four variables which describe the relationship between purchases made in an economy and the amount of circulating currency. We can use this equation to assign a value to a currency based on its utilty…that is, its fundamental usage as a medium of exchange. This, after all, is what the genesis of cryptocurrency was all about.  

The equation is

MV = PQ

M represents the units currency actually circulating in an economy. Hodl’d units don’t count.

V is for velocity. Velocity is the number of transactions an average currency unit will encounter, per year.

P stands for purchases. Its value is the average price of purchases in an economy.

Q is the quantity of these average transactions.

Given any 3 of these variables we can determine the 4th. Now for some application.

Example A: US Dollars

In the US, M1 is the term for all dollars circulating in the economy. According to the St. Louis Fed, dollars are used an average of 5.5 to 6 times per year so we’ll use a V of 6.

Suppose that the average purchase in the US is $50 (P=50), and that the yearly quantity of these purchases is 20 (Q=20).

Therefore, PQ is $1000 and through the equation of exchange must be equivalent to MV. (MV = PQ)

So, what we know is:

• • P = $50

• • Q = 20

• • PQ = $1000

• • MV = $1000

• V = 6

Given a velocity of 6, we can solve for the remaining variable M, the monetary base. To do this, we divide both sides by 6.

This leaves us with M = $1000/6 = $166.67.

And voilà, with only three variables, we’ve just calculated the total monetary base of an economy.

This can be solved for any size economy, but the relevance to cryptocurrency is that the equation of exchange can be applied to specific use cases targeted by niche cryptocurrencies. Let’s look at one now.

Example B: WidgetCoin (WGC)

Imagine WidgetCorp sells widgets for an average of $20. Five hundred of them are purchased per year for an annual volume of $10,000.

Q = 500, P = $20

Now suppose as the sole manufacturer of widgets, WidgetCorp decides to create WidgetCoin (WGC) and require payments be made in WGC. WidgetCorp also has a monopoly, (state-sanctioned of course).

Because it’s a closed system, the new currency has its own velocity. Some speculators are reluctant to spend their WidgetCoins, so we’ll estimate a WGC velocity of 4.

Now we can solve for the monetary base required to support purchases, M, i.e. the value of circulating WidgetCoins.

M * 4 = $20 * 500

4M = $10,000

M = $2,500

So we’ve figured out that the total value of circulating WGC is $2,500, but what is one WidgetCoin worth?

We could simply look at the market price, but price won’t tell us what the actual value is. WGC could be fairly valued, overvalued or undervalued, and as investors this is what we want to determine.

We seek the intrinsic value of a WidgetCoin. To calculate that, we need a critical piece of information – the circulating supply of WGC.

There may be a thousand, ten thousand, or millions of WGC but let’s imagine WidgetCorp was conservative in determining token supply. WidgetCorp wanted each widget to cost 100 WGC, and they issued 12,500 coins.

With the known dollar-value of the monetary base, we can factor in the coin supply to calculate the expected market value of each coin.

In this case, $2,500 divided by 12,500 coins is $0.20 per coin.

Now pretend WidgetCorp instead decided to create 1 million coins.

The same $2,500 divided by 1,000,000 coins is $0.0025 per coin – a quarter of a penny.

If WidgetCorp had ICO’d WGC for 20 cents each, they’d have made a killing. Unfortunately, early investors would have seen the value of their WGC fall by 98.75% as the market adjusted.

Why Bitcoin Bubbles

Wittingly or not, this is what happened in 2017 with ICOs.

It’s also the reason behind Bitcoin volatility. The market price strays from Bitcoin’s intrinsic (i.e. utility) value.

With largely speculative transactions, Bitcoin’s economy has no fundamental drivers of value – no necessary purchases (PQ). Eventually, the market catches on and adjusts the price accordingly.

For a more in-depth exploration of Bitcoin’s intrinsic value, go to Investor Series #1. (At this point, you’re well-equipped enough to skip the first part and go straight to the calculations.)

Implications

The equation of exchange is not only relevant to ICOs, or Bitcoin. The equation of exchange is the single most important equation in the industry, and yet it’s been largely ignored. Eat Sleep Crypto applies it, and you should too.

As the bear market eats weaker currencies, we focus on the value propositions of utilitarian coins in niche markets. Hope is not an investment strategy.

These currencies are the subject of our Investor Series. Our next edition is due this week and will be offered at a discount exclusively to subscribers of Eat Sleep Crypto. We’re covering Monero, one of our favorite coins, and the determined value will shock you.

Keeping with the “utility determines value” theme, free analysis is readily available on Reddit and Facebook, and is worth exactly what it costs. However, if you want to know what we know, it’s going to cost you something.

Right now though, you can get a preview for free.

Sign up for a 5-day free trial of the Eat Sleep Crypto daily newsletter and send us a message to receive a notification when we release Investor Series #3 – Monero.