A common occurrence, from both digital currency proponents and opponents, is the comparison of a digital currency’s market capitalization (market cap) to that of a traditional company. This includes statements like:
In our continuing quest for our readers to understand the language they are using, it’s important to understand that comparing the market cap of a public company to the market cap of a digital currency is like comparing apple and oranges (at this point in time).
The most common way that traditional public companies are valued is by their stock prices. When companies have an initial public offering (IPO) they issue shares in their company thatgive purchasers equity ownership in the company. Stock prices can be determined via a math formula:
1.A company reports their financial earnings (ex. Company A earns $100M)
2.That earnings figure is then divided by the number of stock shares outstanding to determine the “Earnings per Share (EPS)” (ex. $100M in earnings and Company A has 100M shares. $100M divided by 100M is $1 per share).
3.The stock price will likely trade at a price that is above the $1 EPS. That multiplier (known as the Price to Earnings (P/E) ratio) is an indicator of the market’s sentiment about the growth prospects of that particular company or industry. (ex. Technology Companies are often seen as high growth, but Airlines are often seen as low growth. A $1 EPS Tech Company may have a 100x multiple and a stock price of $100, whereas an Airline may have a 10x multiple and a stock value of $10).
4.To bring it full circle, you can find the market cap of a traditional company by multiplying the stock price by the number of shares outstanding.
When the securities first began trading in the late 1700s this system of valuation did not exist. It was over hundreds of years that company valuations and P/E ratios became a standardized consideration when trading stocks.
Buying a digital currency does not give purchasers equity ownership in the issuing company. They also do not have earnings, so you cannot value these currencies in the same way as stocks.
However, there are though leaders that are thinking about what the valuation equations for digital currencies. The most considered post on this topic is from Chris Burniske titled, “Cryptoasset Valuations” and includes this passage:
The equation of exchange is MV = PQ, and when applied to crypto my interpretation is:
M = size of the asset base
V = velocity of the asset
P = price of the digital resource being provisioned
Q = quantity of the digital resource being provisioned
A cryptoasset valuation is largely comprised of solving for M, where M = PQ / V. M is the size of the monetary base necessary to support a cryptoeconomy of size PQ, at velocity V.
This equation has been relatively popular, with over 10,000 “claps” on Medium. However, very few assets currently have a significant enough velocity (V) for the equation to be put into practice. This has caused even Burniske to look for alternate methods:
In 2018, Blockchain based companies need to deliver working products to push the industry forward. Once launched, marketing efforts must begin to acquire users at scale. If companies can accomplish this, it will allow top investors and mathematicians to develop the formulas that help take markets out of the phase where speculation is the main driver of token value.
But it won’t be the same way that we value public stocks!