Crypto fundamental analysis involves taking a deep dive into the available information about a financial asset. For instance, you might look at its use cases, the number of people using it, or the team behind the project.
Your goal is to reach a conclusion on whether the asset is overvalued or undervalued. At that stage, you can use your insights to inform your trading positions.
In cryptocurrency fundamental analysis, though the approach is similar to that used in legacy markets, you can’t really use tried-and-tested tools to assess crypto assets. To conduct proper FA in cryptocurrencies, we need to understand where they derive value from.
In this article, we will attempt to identify metrics that can be used to craft your own indicators.
What is fundamental analysis (FA)?
Fundamental analysis (FA) is an approach used by investors to establish the "intrinsic value" of an asset or business. By looking at a number of internal and external factors, their main goal is to determine whether said asset or business is overvalued or undervalued. They can then leverage that information to strategically enter or exit positions.
The problem with crypto fundamental analysis
So, we need to turn our attention to different frameworks. The first step in that process is to identify strong metrics. By strong, we mean ones that can't easily be gamed. Twitter followers or Telegram/Reddit users are probably not good metrics, for example, as it's easy to create fake accounts or buy engagement on social media.
Note that this metric should be treated with caution. As with active addresses, we can't be sure that there isn't just one party transferring funds between their own wallets to inflate the on-chain activity.
Active addresses are the blockchain addresses that are active in a given period. Approaches to calculating this vary, but a popular method is to count both the sender and receivers of each transaction over set periods (e.g., days, weeks, or months). Some also examine the number of unique addresses cumulatively, meaning that they track the total over time.
Because the cost to mine tends to increase over time, but the block subsidy is slowly reduced, it makes sense that transaction fees would need to rise. Otherwise, miners would operate at a loss and begin to drop off the network. This has a knock-on effect on the security of the chain.
Hash rate and the amount staked
Blockchains today use many different consensus algorithms, each with its own mechanisms. Given that these play such an integral role in securing the network, diving into the data surrounding them could prove valuable for fundamental analysis.
Factors that can influence the overall costs of mining include the current price of the asset, the number of transactions processed, and fees being paid, to name a few. Of course, the direct costs of mining (electricity, computing power) are also important considerations.
Where on-chain metrics are concerned with observable blockchain data, project metrics involve a qualitative approach, which looks to factors like the performance of the team (if any exists), the whitepaper, and the upcoming roadmap.
It's highly recommended that you read the whitepaper of any project before investing. This is a technical document that gives us an overview of the cryptocurrency project. A good whitepaper should define the goals of the network, and ideally give us an insight into:
- The technology used (is it open source?)
- The use case(s) it aims to cater to
- The roadmap for upgrades and new features
- The supply and distribution scheme for coins or tokens
It's wise to cross-reference this information with discussions of the project. What are other people saying about it? Are there any red flags raised? Do the goals seem realistic?
A strong whitepaper should give us an idea of the use case the crypto asset is targeting. At this stage, it's important to identify the projects it's competing with, as well as the legacy infrastructure it seeks to replace.
Ideally, fundamental analysis of these should be just as rigorous. An asset may look appealing by itself, but the same indicators applied to similar crypto assets could reveal ours to be weaker than the others.
Tokenomics and initial distribution
Information about how the asset currently trades, what it traded at previously, liquidity, etc. can all come in handy in fundamental analysis. However, other interesting metrics that might fall under this category are those that concern the economics and incentives of the crypto asset's protocol.
By itself, market capitalization can be misleading. In theory, it would be easy to issue a useless token with a supply of ten million units. If just one of those tokens was traded for $1, then the market cap would be $10 million. This valuation is obviously distorted – without a strong value proposition, it's unlikely that the wider market would be interested in the token.
Nonetheless, market capitalization is used extensively to figure out the growth potential of networks. Some crypto investors view "small-cap" coins to be more likely to grow compared to "large-cap" ones. Others believe large-caps to have stronger network effects, and, therefore, stand a better chance than unestablished small-caps.
Liquidity and volume
A problem we might encounter with an illiquid market is that we're unable to sell our assets at a "fair" price. This tells us there are no buyers willing to make the trade, leaving us with two options: lower the ask or wait for liquidity to increase.
Being familiar with liquidity can be helpful in the context of fundamental analysis. Ultimately, it acts as an indicator of the market's interest in a prospective investment.
Fundamental analysis indicators, metrics, and tools
We’ve already defined metrics as quantitative and sometimes qualitative data used in basic analysis. But on their own, these metrics often don’t tell the whole story. To get deeper insights into a coin’s fundamentals, we should also take a look at indicators.
An indicator often combines multiple metrics using statistical formulas to create easier to analyze relationships. However, there is still a lot of overlap between a metric and an indicator, making the definition quite loose.
While the number of active wallets is valuable, we can combine it with other data to gain deeper insights. You could take this as a percentage of total wallets or divide a coin’s market cap by the number of active wallets. This calculation would give you an average amount held per active wallet. Both of these would allow you to draw conclusions on the network’s activity and users’ confidence in holding the asset. We’ll dive into this deeper in the next section.
Fundamental analysis tools make gathering all these metrics and indicators easier. While you can look at the raw data on blockchain explorers, an aggregator or dashboard is a more efficient use of your time. Some tools allow you to create your own indicators with your chosen metrics.
Combining metrics and creating FA indicators
Now that we're familiar with the difference between metrics and indicators, let's talk about how we combine metrics to better understand the financial health of the assets we're dealing with. Why do this? Well, as we've outlined in the previous sections, there are shortcomings with every metric. Furthermore, if you're just looking at a collection of numbers for each cryptocurrency project, you're overlooking a lot of crucial information. Consider the following scenario:
Transaction count (6mo)
Avg. transaction value (6mo)
Active addresses (6mo)
We're only scratching the surface on the kinds of indicators that can be used. Fundamental analysis is all about developing a system that can be used to value projects across the board. The more quality research we do, the more data we have to work with.
Key FA indicators and metrics
There are a huge number of indicators and metrics available to choose from. For a beginner, start with some of the most popular ones first. Each indicator only tells part of the story, so use a variety of them in your analysis.
Network Value to Transactions Ratio (NVT)
If you’ve heard of the price-to-earnings ratio used to analyze stocks, then the network transaction value indicator (daily) provides a similar analysis. It’s calculated simply by dividing a coin’s market capitalization by the daily transaction volume.
We use the daily transaction volume as a stand-in for the underlying, inherent value of a coin. This concept works on the assumption that the more volume moving around the system, the more value the project has. If a coin’s market cap increases while daily transaction volume lags, the market could enter bubble territory. Prices are rising without there being a matched increase in the underlying value. In the opposite case, a coin or token’s price may stay stable while daily transaction volume increases. This scenario could suggest a possible buying opportunity.
The higher the value of the ratio, the more likely a bubble will occur. This point is usually seen when the NVT ratio is above 90-95. A decreasing ratio indicates that the crypto is becoming less overvalued.
Market Value to Realized Value Ratio (MVRV)
Before we dive into this statistic, we need to understand what realized value means for a crypto asset. Market value, otherwise known as market cap, is simply the total supply of coins multiplied by the current market price. Realized value, on the other hand, discounts for coins lost in inaccessible wallets.
Coins sat in wallets are instead valued using the market price at the time of their last movement. For example, a Bitcoin lost in a wallet since February 2016 will only be valued at around $400.
To get our MVRV indicator, we simply divide the market cap by the realized cap. If the market cap is much higher than the realized cap, we’ll end up with a relatively high ratio. A ratio over 3.7 suggests a sell-off may occur as traders take their profits due to the coin’s overvaluation.
This number signifies that the coin may currently be overvalued. You can see this before two large Bitcoin sell-offs in 2014 (MRVR of roughly 6) and 2018 (MRVR of approximately 5). If the value is too low and under 1, the market is undervalued. This situation would be a good point to buy as buying pressure increases and drives up the price.
The stock-to-flow indicator is a popular indicator of the price of a cryptocurrency, typically with a limited supply. The model looks at each cryptocurrency as a fixed, scarce resource similar to precious metals or stones. Because there is a known limited supply without new sources to be found, investors use these assets as a store of value.
As you can see, stock-to-flow has been a reasonably good indicator of the price of Bitcoin. Bitcoin’s price has been superimposed on the 365 day average of the ratio and shows a good match. The model does have some drawbacks, however.
For example, gold currently has a stock-to-flow ratio of around 60, meaning it would take 60 years to mine the current supply of gold at the current flow. Bitcoin will roughly be on track to have a ratio of 1600 in around 20 years, setting price predictions and a market cap higher than the world’s current wealth.
Stock-to-flow models also struggle when deflation happens, as this would suggest a minus price. As people lose the keys to their wallets and no more bitcoins are produced, we would see a negative ratio. We would see the stock-to-flow ratio flow go towards infinity and then become minus if we displayed this graphically.
Examples of Fundamental Analysis tools
Baserank is a research platform for crypto assets that aggregates information and reviews from analysts and investors. The crypto receives an overall score from 0 to 100 after taking an average of each review’s score. While there are some premium reviews for subscribers, free users can still see a comprehensive overview of reviews broken down into sections, including team, utility, and investment risk. If you’re short of time and need a rapid overview of a project or coin, an aggregator like Baserank is suitable for the task. You should always, however, dive deeper into projects you’re interested in before investing.
As you might have guessed from the name, this tool shows you each network’s fees for the past 24 hours or seven days. It’s an easy metric to use when analyzing the traffic and usage of a blockchain network. Networks with high fees are typically experiencing great demand.
However, you shouldn’t just take this metric at face value. Some blockchains are built with low fees in mind, making a comparison with other networks challenging. In these cases, it’s best to look at the figure in tandem with the transaction amount or another metric. For example, large market cap coins such as Dogecoin or Cardano are low in the overall charts due to their cheap transaction fees.
Glassnode Studio offers a dashboard displaying a wide range of on-chain metrics and data. Like most tools on offer, it is subscription-based. However, the amount of free on-chain data it offers is suitable for amateur investors and quite in-depth. It’s much easier to find all the information in one place rather than gather it yourself using blockchain explorers. Glassnode’s main strength is the vast number of metric categories and subcategories you can browse. However, if you’re interested in Binance Smart Chain projects, you’re very limited here.
Done correctly, fundamental analysis can provide invaluable insights into cryptocurrencies in a way that technical analysis cannot. Being able to separate the market price from the "true" value of a network is an excellent skill to have when trading. Of course, there are things that TA can tell us that can’t be predicted with FA. That’s why many traders use a combination of both these days.
As with many strategies, there's no one-size-fits-all FA playbook. Hopefully, this article will have helped you understand some of the factors to consider before entering or exiting positions with crypto assets.