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Uncovering fundamental analysis for informed investments
Fundamental analysis can be described as the science of identifying when an asset is undervalued or overvalued (Investopedia).
The best time to buy an asset, of course, is when it is undervalued. Many have heard the expression "Diamond in the rough."
As the crypto industry is still in its early stages, it can be difficult to distinguish between the good and the bad projects, as some projects are over-hyped from lots of noise on social media. From employing fundamental analysis, investors can perform more due diligence and hopefully identify those under-valued projects which are worthwhile investments.
The first conceptualisation of fundamental analysis can be traced back to the 1930s in the book Security Analysis by Dodd and Graham which was published in the aftermath of the 1929 stock market crash. This book warned investors of speculative behaviour, and encouraged readers to instead look for assets which were selling below their specified price.
In their book, Graham and Dodd laid the foundation of fundamental analysis. The proposition of fundamental analysis was to meticulously analyse financial statements, studying a company’s fundamentals, and focusing on an asset's long-term potential, to better identify undervalued investments, as opposed to just sticking to candlestick movement, as with Technical analysis.
While it initially started with stocks, over the years, fundamental analysis is now also being applied to other asset classes, given its accuracy in analysing and assessing the value and risks associated with other asset classes.
Also, given the volatility and hype surrounding the crypto world, fundamental analysis can be useful in analysing the crypto market's value.
The earliest application of crypto fundamental analysis was an assessment of the price movements of Bitcoin and some of the earliest altcoins. The bulk of what that entails included technology assessments, whitepapers, technical document assessments, and regulatory assessments.
As the crypto-assets space evolved beyond Bitcoin and other proof of work (PoW) chains following the emergence of smart contracts, more comprehensive approaches emerged. Recent fundamental analysis tools include: crypto project team expertise assessments, tokenomics analysis, reviewing partnerships,, utility assessment,, and crypto-assets network metrics, security audit status; all to assess the intrinsic value and growth potential of crypto.
The uniqueness of blockchain technology and its differences to TradFi assets means that certain tools of fundamental analysis (e.g., discounted cash-flow analysis, price-to-earnings) are not applicable when assessing crypto projects. Below we cover some of the relevant tools for assessing crypto projects.
Before we move on, let's establish the distinction between technical analysis and fundamental analysis, for the sake of clarity.
Fundamental Analysis employs both qualitative and quantitive information to assess a crypto projects intrinsic value, while technical analysis assesses historial price data to try and predict future price action.
Imagine you want to buy a piece of real estate. Fundamental analysis would mean checking the surrounding neighbourhood ti evaluate its potential for growth (e.g. local schools, hospitals, transport links), as well as inspecting the property.
On the other hand, Technical analysis would mean only checking the historical price trends of the house and houses in that area before making a decision on whether or not the property is a good buy.
There are a variety of data points that can inform a project’s intrinsic value. Considerations include the development team, technology, and provided utility,; all of which are covered here:
The parameters for assessing a crypto-assets project’s team are quite simple. You ought to be on the lookout for reputable educational background, past work experiences in a relevant field, previous successes with another company, and perhaps they have even all worked together previously at another crypto project.
Teams with great direct or complimentary professional experiences, and a great reputation can be a clear indication of a great product.
Blockchain technology (Bitcoin, Ethereum, Polygon) is the infrastructure that powers a crypto-asset (e.g. BTC, ETH, MATIC). The blockchain technology is like the power station and power lines that distribute the electricity supply (crypto) to end-users.
A sound blockchain infrastructure, is essential to a token's overall utility and can dictate a project’s price action in the market, just as a sound power line is essential for great power delivery. A stronger blockchain technology can lead to the processing of a higher number of transactions per second (TPS) which is needed for a blockchain to scale as more users join the network. A blockchain technology covers areas such as scalability, security, fees and transactions transparency.
Although Bitcoin’s PoW mining protocol and its high hash rate have drawn a lot of criticism for its energy consumption levels, the PoW mechanism is key to this blockchain’s security. Bitcoin is however gradually becoming greener, in fact around 50% of BTC is mined using renewable energy sources (X).
Ethereum's blockchain, on the other hand, doesn’t just offer transaction security and network strength. Its self-executing l smart contract infrastructure also provides a truly decentralised network for thousands of crypto-assets. This in turn all requires Ether as network fees for computing cost for operating on Ethereum's Virtual Machine (EVM).
Blockchain technology directly enhances the utility that a crypto can offer, this can have a corresponding future price impact.
Following the losses from the 2017 ICO bubble, investors should be aware of the facade that surrounds ICO-type tokens. When analysing a digital asset you want to invest in, it is important to consider its use-case and token utility value and how important and practical it is.
Ethereum (ETH): the pioneer in smart contract solutions; which enables thousands of decentralised applications (dApps), non-fungible tokens (NFTs), and general smart contract applications. These activities require Ether for network fees given its primary utility within its infrastructure, creating demand for Ether.
Solana (SOL): has a utility across its smart contract infrastructure for lightning-fast micro-size transactions, which were nonexistent at the time of its launch. Solana, however, may have sacrificed the highest levels of security for speed.
Avalanche (AVAX): offers great scalability and security for smart contracts, like no other, and has its primary token utility from network fees paid.
At the end of the day, a crypto-asset with a practical purpose is more likely to gain traction over time, driving demand and influencing price action.
This leads us to the next point, which is a crypto’s tokenomics and distribution plan.
A crypto’s tokenomics and planned distribution are two internal and external factors, at the core of its valuation. These two factors can make or break the value of a digital asset in the crypto market.
Take Bitcoin, for example. Bitcoin tokenomics has a 131-year-long deflationary plan built into its supply. Every four years, its block reward from its miner's incentive is halved by 50%. This is against a finite 21 million total supply. This creates an organic scarcity for Bitcoin transactions, driving demand high against a fixed token supply, and limiting how many units are introduced over time.
Ethereum, on the other hand, does not have a finite supply like Bitcoin; rather it has an algorithmic controlled issuance rate. The Ether has a capped supply to limit its inflation, using a recent 2021 update called EIP-1559 that introduces a fee-burning mechanism to reduce its total supply over time, potentially making it a deflationary asset.
Also, Ethereum allows mining nodes (individuals whose computing power keeps the network operational) to charge higher fees during periods of high network congestion. This automatically translates to a surge in prices with the growing use of the network.
With new token launches, you should review the distribution plan the project's dev team has coming.
A Quick Tokenomics Questionnaire
A balanced supply and distribution scheme builds trust. Also, a controlled token release can create scarcity and boost prices, as we have seen with Bitcoin and Ethereum.
Partnerships are a major indicator of how well and how prepared a crypto team is in delivering their use-case promises. It also gives an idea of where a team is headed. Great and meaningful partnerships go to show a team playing the long-term game.
Solana (SOL), in its early days, forged strategic alliances with tech companies like Serum (SRM) and Chainlink (LINK). The goals were to incorporate decentralised finance (DeFi) and decentralised oracle solutions, as we now have with Solana for its smart contract ecosystem.
A good way to spot a great project is the type, nature, and intent of its direct and strategic alliances. Great partnerships generally mean a good reputation and longevity.
Whitepapers and technical documentation contain the blueprint of a token’s utility, making it a great piece of info in its valuation. With it, you can gauge the project's credibility, adoption, technology, and governance.
With whitepapers and project documentation, you want to check for the project's purpose, technology, use cases, token utility, and tokenomics. From each document's abstract or executive summary, you want to understand what the value proposition of the crypto is from a use-case and token utility standpoint. Drawing from Warren Buffet's good old fundamental valuation guide:
“Never invest in a business you cannot understand."
At the end of the day, you need to understand and make sense of a crypto-assets' value proposition. There has to be a real need for the use-case. The whitepaper should show what real-world problems it addresses and how it employs the blockchain, and any other stated technology, to do this.
A thorough code audit assesses a crypto's smart contracts and underlying technology for vulnerabilities or weaknesses. This is crucial to avoid potential exploits or hacks. Audits should come from reputable third-party auditing firms. A great audit report should show transparency in detailing identified issues and their resolutions.
A crypto-asset that has undergone successful audits by an established security firm like CertiK or Trail of Bits, and has critical issues addressed, demonstrates a commitment to security.
Aave (AAVE), for example, underwent multiple audits and code improvements after its launch, which is generally a good sign of commitment to security. Crypto projects with no audit reports or unfounded audits from untrustworthy firms are a red flag. Also, unresolved critical vulnerabilities are a major red flag.
You also want to be on the lookout for bug bounty programs, as well as ongoing vulnerability assessments and responsible disclosure policies.
For example, projects like Ethereum (ETH) and Cardano (ADA) have well-established security protocols, significant bug bounties and actively have addressed past vulnerabilities.
Regulatory and legal compliance are major determiners of a crypto's long-term value. Several cryptocurrency platforms and token-based projects have gone belly up just for stepping on a legal or regulatory landmine.
Investors, in their analysis, ought to check if the crypto complies with relevant regulations and follows industry best practices, for all markets it seeks to enter, or sell to.
Non-compliance or pending legal issues are red flags and pose significant risks.
A crypto’s market cap is pretty much a straightforward representation of its total value at the time it is being calculated. It is a measure of the current price multiplied by its total circulating volume (supply). It's crucial to remember that a high market cap does not accurately tell how much value a crypto-asset is worth.
Rather, it can give you a rough sense of where a digital asset stands in the market, relative to other assets. A high market cap is generally seen as more established and recognized. Low Market Cap, on the other hand, may suggest that the crypto is relatively unknown and, of course, undervalued.
A promising low market cap project could represent a high-risk/high-reward buying opportunity if it is deemed from sound fundamental analysis that it is under-valued. However, it can also indicate higher risk and less liquidity. The best place to find the market cap is from on-chain crypto-asset indexing platforms and not exchanges. A great place to find these on-chain metrics is sites like Coingecko. The vast majority of investors keep an eye on these metrics across these platforms.
This is how easy it is to sell or buy a token, without disrupting prices, in the process. High liquidity means the market thinks an asset is worth what its quoted price is, hence there is someone somewhere willing to buy it for what its market price is and vice versa.
Liquidity is generally influenced by the number of buyers and sellers in the market and the overall depth of the order book on exchanges.
Volume is simply the measure of unit buys and sellouts a crypto has over a given period. This measure is also considered with technical analysis as it is with fundamental analysis.
High volume can indicate either strong selling or buying, you want to be on the lookout for projects with growing demand volume.
Traditional fundamental analysis tools like price-to-earnings ratio are not relevant to crypto as they don’t generate earnings in the same sense. As such, there are other quantitative tools for assessing crypto projects: Network Value to Transactions Ratio (NVT)
Network Value to Transactions Ratio (NVT) gives an on-chain insight into a coin's value from what its network's activity reveals about its transaction value. NVT gives an assessment of the valuation and health of a token’s network, providing on-chain activity insights as it concerns a digital asset’s value.
How NVT is Calculated:
A great place to find this transaction count is on a blockchain explorer. For Bitcoin, the Blockchain Explorer is a good one, for Ethereum or ETH-based tokens Etherscan is the go-to explorer, and for Binance Smartchain tokens, BSC is the most recommended.
Afterward, NVT is obtained by dividing the market capitalization of a token by the daily transaction value. That is:
NVT = Market Cap / Daily Transaction Volume.
A high NVT suggests that the market capitalization of a crypto surpasses its daily volume, indicating a likely overvaluation. And a low NVT means a crypto is undervalued.
NVT gives a reality check on where the current market price is headed. An overvalued crypto asset simply signals that prices will eventually return to their actual value and is likely not the best time to buy an asset.
Market Value to Realised Value Ratio (MVRV) measures a crypto-assets's market value in relation to its realised value. This helps investors assess its true valuation.
How MVRV is Calculated:
To calculate MVRV, you have to divide a crypto's market cap by its realised capitalization. The realised cap is an attempt to measure the last cap of a token across its various holding wallets. The realised market cap discounts for the actual cap of every token, from the last time every wallet holding the crypto was active.
The reality is that the market cap of an asset is only fairly accurate for active addresses. Since only active addresses bought the tokens at the present market prices or are close to the current market price. Inactive wallets are likely bought at far cheaper prices, showing many traders or investors waiting to take profit. This, by the way, depends on the digital asset and how long a wallet has been inactive.
An MVRV significantly above 1 shows signs of overvaluation, as the current market value exceeds the average purchased value at which some investors bought the token.
On the other hand, a low MVRV that is below 1 suggests undervaluation, which is a sign to get into the market. The result provides insights into whether the asset is overvalued or undervalued.
As the crypto market evolves, investors will continue to recognize the importance of understanding crypto fundamentals that drive value, and investment decisions, and not just chasing price trends.
Whether it's Bitcoin's scarcity, decentralised nature and robust security, Ethereum's diverse EVM ecosystems, or Solana's lightning-fast transaction solutions, sticking to the fundamentals will continue to mean the difference between the winners and losers, and that is something to think about.
This article is not to be considered financial advice as it's for informational purposes only. Crypto-assets investments carry significant risks and past performance is not necessarily indicative of the future nor a reliable indicator of the likely performance of any investment.As you are likely aware, in-depth research and sometimes the help of an expert may also help you to avoid common pitfalls. If you need such help, make sure to contact a certified financial professional.
Stay safe, stay informed!
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