What is Fundamental Analysis?
What you'll learn
- A definition of Fundamental Analysis
- A framework for analysing future value of crypto projects
- Ways to quantify ambition & performance of crypto projects
- The importance of lateral thinking in investing
Investing in a cryptocurrency is a very different discipline from Trading in it. Trading attempts to profit from short term Technical Analysis; interpreting price movement and volume (we cover Technical Analysis in a separate article).
Investing is an attempt to profit from a cryptocurrency's long term success, with the decision making process relying on Fundamental Analysis.
Fundamental Analysis within traditional finance will look at the opportunity to profit by investing in a company - through both public or private equity - by referring to metrics that describe its financial health and forecast future earnings potential.
In relation to publicly traded companies - traded on a stock market - the most common metric is Price to Earnings Ratio (aka PE Ratio).
PE Ratios are calculated by dividing the Share Price by Earnings Per Share and are a simple yet effective way of estimating whether a company is over or undervalued.
Unfortunately, cryptocurrencies don’t function like traditional companies, with few generating recognisable revenue streams. They also don't (in general) raise capital by selling shares, but instead issue their own tokens; the value of those tokens fluctuates in relation to the future potential for revenue generation, as well as perceptions of the intrinsic value of underlying blockchains, networks of participants and users or underlying assets.
So any decision around long term investing in cryptocurrency projects, must use a framework that can assess the value of those things, which is what Fundamental Analysis boils down to.
Whereas Technical Analysis is very prescriptive, Fundamental Analysis within crypto is not just analysing the potential success of a given project but broader socio-economic change, which requires more lateral thinking and some creativity.
As daunting as that might sound, when looking at a specific cryptocurrency project, you should always start with some simple, but fundamental questions.
What problem is a cryptocurrency trying to solve?
A good place to start with Fundamental Analysis of a cryptocurrency is asking the simple question - what problem is it trying to solve?
This may sound obvious, but it is very easy to be seduced by complex language and ambition, without thinking about what a cryptocurrency does and what real world problem it solves.
If it doesn’t solve a real world problem, it is unlikely to provide long term value. Hype can sustain interest during a bull market, but as with the dotcom bubble, businesses that lack a clear use case will eventually fail.
We saw this during the ICO boom of 2017/18 when projects generated astronomical investment and unrealistic expectations of future value on basis of flimsy concepts, often no more than ideas.
Dragon Coin is a good example. It raised $320million from an ICO and traded at an all-time-high of $2.40 in March 2018, but three years later, with its development abandoned, price is down 99.74%. The most obvious reason being it had no clear purpose.
Its website is poorly put together, which would be an immediate red flag, and it describes itself as the 'Entertainment Token' but text attempting to explain what that means reads like word soup.
Any crypto project should be able to articulate the problem being solved in a single sentence and you’d expect to find it prominently on the project website and on page 1 of something called a Whitepaper.
Here’s what the first paragraph of Bitcoin’s whitepaper says:
This very succinctly explains what Bitcoin is and the problem it is solving. The remainder of the document then goes on to explain how Bitcoin solves the double-spend problem, in just nine pages. A good white paper should therefore cover:
- What the project does
- Why it is exists - details of the specific problem it solves
- How it intends to solve the problem
- The team behind the project
You can understand a lot about a project simply from a Whitepaper, such as the quality of the content, how succinctly it covers the what, why and how, along with the reputations of the people directly involved or supporting the project.
Many early crypto Whitepapers were lazy rip-offs, copying text directly from the internet. Obviously the Bitcoin Whitepaper contains no details of the person behind it; it succeeded purely on the strength of the idea and clear understanding of the problem it was trying to solve.
Bitcoin’s whitepaper is only nine pages long. Page one is dedicated to articulating the what/why, with the rest of the document - aside from the conclusion - explaining exactly how Bitcoin solves the double spend problem.
Those eight pages essentially validate the headline claims, and the devil is always in the detail. A cryptocurrency may claim to be an excellent store of value but not provide details of its total supply, or claim to be decentralised yet have a very narrow command and control structure.
It might seem daunting to evaluate technical specifications but a good white paper should be able to articulate its function without resorting to dense language.
What you are looking for is reassurance that a project can do what it says on the tin.
Standing on the shoulders of giants
If you are investing your hard-earned money, you need to have confidence in your own decisions but this doesn’t mean you cannot refer to the opinions of others to help validate the claims in a white paper or live project.
As the recent WallStreetBets drama highlighted, forums like Reddit can rival professional analysts in terms of the depth of their insight, so are invaluable sources of information and opinion. Take advantage by referring to research that others have done if it appears reasonable and unbiased.
Other useful resources include:
- Telegram Groups
- Any official social media
- Twitter OGs
Usage & adoption metrics
As part of the description of how a cryptocurrency project intends to solve the specific problem identified, should be reference to data that quantifies both the problem and the solution.
Data that quantifies the problem enables you to get a sense of the size of the opportunity and is useful for evaluating before a project is live.
This will include macro-economic data, information related to whatever can be considered the incumbent that is being challenged and more general adoption models.
If the project is focused on fast, low value/cost, permissionless transactions then you might look at the size of the market for international remittance, existing services and any attempts to focus on a specific niche within that.
That is a difficult bundle to unpack, and highlights the difficulties of Fundamental Analysis. You'll need to do desk research, pulling together available resources online and where existing reports aren't available, use proxies such as Google Search trends data or Reddit subscribers. Anything that is a reliable barometer of sentiment towards the idea or solution.
One of the simplest ways to evaluate interest in a given cryptocurrency project is using Google search sentiment, which is available via the Google Trends feature. This enables you to look at the historic interest in a search term, and see when the peak of interest was reached.
Google Trends uses an index measure, where 100 is the peak of interest, and 0 being no search interest at all. You can zoom in and out of time ranges, and drill into country data.
What is so interesting about looking at Worldwide Google Trends data for the search term 'bitcoin' going back to publication of the whitepaper is that the peak for search sentiment was in 2017, during the climax of the bull market. The price has since risen 200% beyond that high, yet general search sentiment is yet to reach that level.
The conclusion: recent price increases are not being driven as much by recreational investors as in 2017, but more by institutional money. This leaves a lot of room for further interest when the average person starts googling to know more.
Notice the difference that location makes to the trend. If you filter by countries with weak currencies such as Argentina, Turkey, Venezuela or Nigeria (below) you get a very different shaped line graph. This can provide valuable insight into where demand is coming from and how that might influence price or interest in crypto services specific to problems faced by Nigerians.
Quantifying the Solution
A great example of a bitcoin price model that quantifies the potential value based on its actual function is the Stock-to-flow, created by Plan B for Bitcoin.
Being the first cryptocurrency and a completely novel technology it was very difficult to model the potential impact of Bitcoin's potential as a store of value.
Stock-to-flow focuses on scarcity as the key characteristic of a store of value and relies on an existing approach for measuring scarcity within gold, silver and other scarce commodities. The result is a price model that has not only proved accurate, but invaluable for Fundamental Analysis. You read more about bitcoin price prediction models in our blog.
Data that quantifies the solution enables you to measure the progress of the project once it is live. It will vary from project to project but there are some key things to consider.
Ignore any metrics that can be gamed and that aren't linked to the project's fundamental function. Good examples of red herring metrics are Twitter followers, Blog views or White Paper downloads.
Also be wary of performance metrics that are conducted on testnets, there is no substitute for seeing something functioning in the wild.
On Chain Metrics
Though Fundamental Analysis is a different discipline to Technical Analysis, they do at times overlap. We've already introduced the value of on chain metrics as leading indicators of price change. When looked at in a broader sense, they give invaluable insight into the potential long term success of a project.
For cryptocurrency projects that are live on-chain metrics will tell you whether the blockchain is actually being used. Look for relative numbers to get a sense of growth rate, as well as moving averages.
Metrics like Transaction Count, Transaction Value and the number of Active addresses will give you a sense of whether the underlying blockchain has users, but don’t necessarily define success.
Address distribution - the proportional distribution of coins or tokens across users - is perhaps more meaningful as it can give a good idea of the type of user. Are they all addresses with tiny balances, is there a healthy distribution, what is the velocity of circulation of coins?
You should also look at a metric for the specific consensus method being used. Hashrate is relevant for Proof of Work, Amount Staked/Number of Contributors for Proof of Stake.
Whatever the consensus mechanism, try and find a metric that is meaningful and cannot be faked or fudged, and consider whether the network is supported by subsidies or concessions.
For the technically savvy, this kind of data can be accessed by running a node, or pulling from an API. If you’re not comfortable with that there are resources available online that provide data, though you may need to dig around for the smaller projects.
There are websites that provide details of fee generation, the number of active validators and the amount of value locked. These are all very useful and meaningful data points to help establish the potential future value of a project.
Competition & Differentiation
Though the what, why and how framework are useful, alone they aren’t enough to charge ahead and invest in the long term success of a new cryptocurrency.
Right now there are over 3,000 coins and tokens each proclaiming their own unique use case. Success will depend on whether they are the only project offering a solution to a known problem.
If a cryptocurrency project isn’t first to market, then it can only succeed by providing a superior solution, being faster in developing its solution compared to existing providers or offering some meaningful differentiator. This could include:
- More developers
- A better business structure
- Better marketing & articulation of the project
- More investment
Though cryptocurrencies don’t have familiar revenue based metrics they do are metrics that are useful.
This is the number of coins in circulation (aka Circulating Supply) times price. On its own it's a metric that should be treated with caution, as it can be spoofed or reflective simply of manipulation like pump and dump.
If however, you combine Marketcap with Transaction volume, you can create a hybrid index which is more meaningful.
Token Distribution & Economic Model
As cryptocurrency projects issue tokens to finance themselves they will publish a scheme for how tokens will be distributed. This will often include a 'premine' which essentially means a percentage of the supply of tokens will be created outside of any proposed mining mechanism - essentially creating value out of thin air.
This has been a point of contention with ICOs and new crypto venture, with premines often associated with an attempt to cash in early.
The distribution of tokens will provide very valuable information about how the project intends to finance itself, reward its investors, team, community and users. If the project is serious it will include lock-up clauses which mean that those rewarded with tokens cannot cash them out until after a specific period has expired.
Token distribution is one element of the economic model for managing the supply of tokens or coins which has a critical impact on scarcity and price. Given Bitcoin is form of digital cash, certainty over its supply - fixed at 21 million - and governed by a very clear issuance mechanism, is one reason why people are willing to invest in. Any project without a clear economic model, or a supply that isn't capped or can be easily changed, is one to be wary of.
Seeing into the future
Given cryptocurrency is transformative, assessing the future impact of a new technology can be hard. Tesla is a great example; it is a publicly traded company with financials - including PE Ratio - but x7 increase in its share price in 2020 wasn’t driven by current performance.
Some of that speculation might have come from the opinion on macro-factors like future adoption of electric cars as well as influences that are harder to predict, such as development of battery technology, changing attitudes to fossil-fuel based cars, and autonomous vehicles.
But equally, parallel developments, such as the ease of share trading played a huge part, and how those new traders valued the charisma of its CEO - Elon Musk. So in that sense, fundamental analysis needs to consider subjective factors.
When you look at the impact of Covid19, you are into the realm of unknown-unknowns, solutions for problems that don’t even exist.
What this means is that investing sometimes requires you to look into the future, rather than things as they are now. The growth of the internet destroyed bricks and mortar businesses like Blockbuster, and created an entirely new way of delivering business and consumer services that we now take for granted.
If that kind of change is coming in relation to blockchain technology, where will the impact be greatest and is adoption likely to follow a simple linear path? There are no certainties here, and at a very general level the labels Bull and Bear Market - referring respectively to optimism and pessimism around price - gauge sentiment but more specific models exist that describe how new technologies are adopted.
Some of the most commonly mentioned in relation to cryptocurrency are:
Diffusion of Innovation (Everett Rogers)
Shows adoption following a normal distribution curve across groups of adopters with varying characteristics and motivations. The critical point of adoption is called 'jumping the chasm' when adoption moves from innovators & early adopters (making up 16% of all adopters) to the mainstream. Many analysts believed we are at that point now with crypto & blockchain.
Gartner Hype Cycle
This is a branded model produced by Gartner that visually maps the path of a new idea or technology through distinct phases starting with a technology trigger, peak of inflated expectation, trough of disillusionment, slope of enlightenment and eventually a plateau of productivity.
Elliot Wave Principle
The Elliott Wave Principle looks at collective investor psychology, which it suggest moves between optimism and pessimism in natural cycles. These mood swings translate into patterns that correlate to price movements at each of five broad stages.
Entry point & DCA
Fundamental Analysis is broad and far reaching, with this article only skimming the surface. At some point however, you'll need to draw a line and decide whether to invest or not. Though Technical and Fundamental Analysis are very different approaches they can complement each other. If you’ve conducted your Fundamental research on a cryptocurrency that is already live, Technical analysis can help you decide when to make an entry point.
If you aren’t comfortable with investing in one lump sum, then you can simply take the Dollar Cost Averaging approach, discussed early in this section.