Fundamental analysis, also known by its acronym AF, is a method used to calculate the real valuation of a financial asset. This type of analysis makes it possible to determine if said asset is undervalued and has the capacity to continue growing in price, or if it is rather overvalued and may depreciate sooner or later. Its name is based on the fact that it is the study of the fundamentals of the asset. In the case of bitcoin, for example, of its monetary policy: its scarcity, the rate of issuance and its adoption and use by people.
What is Fundamental Analysis (FA)?
The objective of this type of analysis is to determine if the investment that is planned to be made is really valuable or if there are other market opportunities with greater growth potential. That is, this information can be used to enter or exit positions strategically, generating greater profits or avoiding long-term losses.
FA experts manage to calculate the “real” price of these assets by studying a series of financial values and macroeconomic conditions that affect the behavior of cryptocurrencies and other instruments such as stocks and bonds.
Fundamental analysis is widely used in the financial system. But with the entry of cryptocurrencies it added new variables that affect the value of an asset. Investors cannot use efficiency tools, such as the earnings generated by a share per year, since the value of a cryptocurrency is nourished from various sources and is affected by different elements.
To apply fundamental analysis to a cryptocurrency such as bitcoin, not only financial aspects are taken into account, data from public networks are also evaluated. These are known as “on-chain metrics”.
Bitcoin Elements for Fundamental Analysis:
For example, the main addresses of hodlers, the value of the transactions, the number of active addresses and the hash rate in the case of being a Proof of Work (PoW) network, among others.
Aspects such as the ideology of the project, its group of developers, the community that supports it or its technical proposal : its White Paper , are also taken into account . With fundamental analysis, the idea is to have a broad vision of what is happening in the market and how this contributes to the value formation of cryptocurrency.
What is the use of fundamental analysis in markets like bitcoin?
Fundamental analysis is a tool that allows evaluating the financial risk to which an investor is exposed when allocating capital to an asset. This is because, if an asset is undervalued, it can be assumed that it will increase in price over the months or years. An investment in an undervalued market can yield long-term gains. But if said asset is overvalued by demand, it will eventually decrease in value when participants lose interest.
Collecting all kinds of information that affects markets such as bitcoin, ether or monero allows investors to have a clearer vision of the real value of the asset and its long-term behavior. They can also learn to forecast how the value of a currency will react to different events.
Limitations of Fundamental Analysis:
There are fortuitous factors that cannot be forecast and have a strong impact on the market. For example: the decree of the coronavirus pandemic and its impact on the market. Neither the fundamental nor the technical analysis could foresee it.
Also, it is unlikely that it will be possible to determine when a big-name company will adopt bitcoin and, due to their decision, this will have a positive effect on its price. Bottom line: Cryptocurrencies remain highly volatile assets, and it’s hard to be prepared for their every move.
Network data
As we have mentioned, for this type of analysis the behavior of the network must be taken into account. Next, we will delve into some of the essential information.
The data on-chain is information of what happens directly in the network that can be seen in real time . We refer to data such as the number of active nodes, the average price of transactions, the richest addresses and even the commissions that are paid on the network.
This information comes from nodes connected to the Bitcoin network or the blockchain of the asset that will be studied and can be seen on various portals. For example, websites such as Bitinfocharts, Blockchain.com, Coin Dance, Glassnode or Ycharts.
Number of active addresses
One of the first data to analyze the value of a cryptocurrency is the number of active addresses in its network. This metric measures the number of addresses that are operating at a given time , which can be translated into how many users are actually using the network.
In networks like Bitcoin, a user can have several public addresses. That is why the total number of addresses created is not a reliable measure to talk about the adoption of cryptocurrency. It can also happen that a person stops using an address because they have lost access or no longer have an interest in the asset. This direction cannot be taken into account in an analysis that seeks to capture the reality of the market.
If this accumulation is in line with the rise in price of a crypto currency, then it can be said that its price is reacting logically to the increase in demand.
Number of transactions and their average value
Another widely used metric in the fundamental analysis of cryptocurrencies is the number of transactions that are registered on the network daily. This is used to calculate how much activity takes place on the blockchain.
Networks typically start out with low transaction volume. With the passage of time and the increase in its use, the number of transactions on blockchains such as Bitcoin and Ethereum exceed thousands. The currency can be said to be useful to a significant population based on that behavior.
Problem with the number of transactions:
While this metric can demonstrate the vitality and usefulness of a cryptocurrency, it does not always point to actual activity. For example, a single user can make multiple transactions to a single address, inflating the volume of activity. It is important to compare it with the number of active addresses and the value that users transfer.
Some analysts prefer to examine transactions, but pay attention to the average value transmitted by users. They follow the most common amounts that users send on the network day by day, or month by month. The objective is to know how much money is moving within the blockchain network , as well as how much the owners of this asset are willing to operate.
Net millionaires
Whales, as owners with large holdings of crypto assets are called, are also an important number to consider when considering whether or not to invest in a cryptocurrency.
This metric demonstrates how many people are willing to invest large amounts of money in the market and determine if the value of the asset is truly decentralized. In other words, it is a measure that helps us exemplify what the distribution of cryptocurrencies is like among all users of the network and how much power a few have.
In a market where decentralization is one of the most outstanding values, it is necessary that the distribution of wealth is also decentralized to avoid price manipulation. More than 50% of the issued coins should not be controlled by a minority, since a sudden sale of their holdings would affect the value of the assets.
Addresses are not people or entities
It is not a guarantee of anything to see the separate addresses, because the same person could accumulate, for example, 10% of the supply of a cryptocurrency and we would not know it because they were loose in many addresses.
It is vital that investors check the lists of “main accounts” or “addresses”. This way they will know not only which are the richest addresses, but how much of the total assets are in circulation.
Network fees
The transaction fee can reveal how much demand there is among users for space on the blocks of networks like Bitcoin. As we have explained before, studying the fees can be used to determine how users compete to transfer their coins and how much they are willing to pay to do so.
Hash rate or amount of staking
Currently there are various consensus algorithms between cryptocurrency networks, two of the best known being the Proof of Work (PoW) with which Bitcoin works and the Proof of Stake (PoS) with which the new version of Ethereum works.
These mechanisms are closely related to metrics such as the hash rate and the amount of staking. Both can help us gauge interest in mining, the effectiveness of transaction processing, and even the security of the network.
The hash rate measures the processing power a network registers, a number that varies depending on how many miners are connected. The higher the hash rate, the higher the number of active miners.
The amount of staking , which is nothing more than the funds deposited by users to participate in the confirmation of transactions, can also be a measure that helps us determine how much interest there is in the community for the network to work optimally.
The project, its philosophy and its community
In addition to reviewing the metrics of the blockchain networks, it is also important to fully understand the public face of the cryptocurrency. Every cryptographic asset has an image, shaped either by its technical documentation, its ideological proposal or its marketing team. This “image” is fed by the developers who contribute to its operation, the founders of the project and the community that uses it.
Read the white paper
It is recommended that anyone who is going to invest in a cryptographic asset first read its technical proposal. For this, the ” white paper ” (or white paper in Spanish) of the cryptocurrency is essential in order to know and understand the characteristics of its network.
These documents provide information about the operation of the network where the asset is issued. Likewise, it explains what the currency has been created for and what its true use is. All the technical details are reflected in the white paper.
When an investor goes to the white paper , they will not only learn more about the cryptocurrency, but they can also compare the project proposal in relation to the discourse of the community, the intentions of its founders, and even the ecosystem that develops around it. So you can determine if it is a really useful financial instrument and not a fraudulent proposition.
Value and utility proposition
As the cryptocurrency white paper is read, investors may notice that they possess certain characteristics that give crypto assets true value and set them apart from other projects. This is known as a “value proposition” and they are those elements that make a cryptocurrency unique and useful in the ecosystem.
To determine the value proposition, the analyst must answer a series of questions, such as what that cryptocurrency is used for or if it solves a particular problem.
What makes a cryptocurrency valuable?
A cryptocurrency that solves a critical problem, and has an improved proposition, has a better chance of increasing its price over time.
The value proposition of assets like Bitcoin is its decentralization and security . On the other hand, networks like Ethereum propose greater functionality with smart contracts; while Monero stands out for its privacy. These characteristics make them unique products and expose them to specific markets and audiences.
Competition
After recognizing the strengths of a cryptocurrency, we can compare it with other projects that have similar value propositions, monetary policies, or capitalizations. The idea is to identify which are the strengths and weaknesses of each asset. Criticisms of cryptocurrencies and their potential vulnerabilities are also useful comparators.
For example, we can compare Monero, Zcash, and Grin because all three projects are focused on privacy. Based on this, we could answer, for example: Which of these projects have the most anonymous and secure transactions?
Networks such as Bitcoin, Litecoin and Bicoin Cash share the same consensus algorithm and can be evaluated for security through their hash rate . Other projects with smart contracts, such as Ethereum, EOS and Tron, can be valued based on how much development they have and their activity.
Founders and developers
When analyzing a cryptocurrency, all background is important. In this sense, it is useful to investigate who are the founders or the team of developers behind the asset.
It is time to clear up doubts about how reliable the project is at the level of security and legality, which can be answered by meeting its figures. This increases transparency around the project.
Another important point is how many years the project has been on the market. As long as a product survives the test of time and its development is sustained, it can be said that its asset is maturing to reach stability.
Where do I find information about developers?
Reviewing the technical documentation in public repositories such as Github, in case its development is open source, can be a very useful tool to monitor cryptocurrency updates. If the development is constant, it is a good symptom.
Community
Finally, cryptocurrency projects are formed and enriched by the people who use them, improve them and promote their adoption. The community keeps a cryptocurrency alive, and the more committed it is to its development, it can be said that it is a healthier market.
It is advisable to review social networks, forums and groups dedicated to the discussion and dissemination of the cryptocurrency in which you are going to invest. For example, on Twitter, Discord, Reddit or Telegram you will be able to see if there are people who are willing to keep the project alive in the long term.
Enthusiasts or Promoters Beware:
Although communities are important, it should be remembered that you always have to be careful. The people that make up these groups can give advice or interpret the market according to their beliefs or needs, advising to invest in certain assets that are not really profitable.
Financial metrics
Financial metrics, as its name says, are all those data that concern the financial reality of the cryptographic asset. In this sense, the analyst is immersed in information such as price, market capitalization and even monetary policies.
Market capitalization
Market capitalization is calculated by multiplying the supply of current assets by the price of each unit. If you have more than 19 million BTC in circulation by the year 2022, these are multiplied by the value of the currency at the time of consulting it.
This metric helps to represent the value of a network, or can also be viewed as the hypothetical cost of each cryptocurrency at a given time. Market capitalization can be used to determine the growth potential of a market.
For example, some investors believe that networks with a small market capitalization are more likely to grow. However, those cryptocurrencies that have the largest market capitalizations also tend to be the least volatile in price because they are less prone to manipulation.
But market capitalization is not a foolproof metric. This can be not very transparent, since it is not possible to filter those coins that stopped being in circulation due to the loss of access to an address or because they have been burned. In this sense, the market could be valuing for more (or less) than what is actually said.
Transaction volume
The daily buying and selling volume can indicate the interest that a community has in a specific asset. A high volume of transactions can determine that there is a high demand .
Also, cryptocurrencies with large transaction volumes tend to be traded on more exchanges. They are assets that are easy to sell and, therefore, have highly liquid markets. Liquidity is a measure of change and utility, so it contributes to the value of the currency.
Crypto assets with large market capitalizations typically have daily volumes in the billions of dollars.
Cryptocurrency ranking
Those who want to carry out a fundamental analysis can also be guided by the price of the asset. There are rankings where the coins are ordered in relation to which ones have the best market capitalization or price for the moment. Users can evaluate the performance of one asset in comparison to others.
Some believe that lower-priced cryptocurrencies have more opportunity for growth than those with a lot of value, such as bitcoin. However, these types of coins that are just beginning to appreciate tend to be much riskier investments because their market is just taking shape.
There are other assets that tend to maintain a relatively stable price for certain periods, so it can be a safer investment in the long term. The decision of whether or not to invest will depend on what type of strategy the participant is applying.
Asset distribution
The distribution of tokens is also an element that has a huge impact on the price of a market. In this sense, every investor must know how the project launches the assets to the market and puts them into circulation.
There are various distribution models. For example, some cryptocurrencies are issued through mining and enter the market by buying and selling. There are others that have been distributed by an Initial Coin Offering, a kind of pre-sale. There are also assets like stablecoins that are created by a centralized entity or smart contract after collateral is posted. And depending on the modality, the interests of the participants and coin owners will be different.
Initial Coin Offerings can benefit a few who have gotten in early. It can also happen that the launch price deflates over the years and investors lose money.
In the case of mining, premining situations can also occur. Some or all of the coins are mined before the network is released to the public. This favors only the founders and developers, while putting the rest at a disadvantage.
Monetary policies
Cryptocurrency protocols also determine their monetary policies. Not all currencies comply with the same issuance scheme, and it is necessary to take this into account when analyzing said asset . A determined emission is not the same as an uncertain one.
Some crypto assets have a maximum amount to be issued. Bitcoin is the prime example of this policy, with its cap of 21 million BTC. On the other hand, there are those currencies that are created in an unlimited way, since their monetary focus is more towards use and non-accumulation of the asset is promoted. The Dogecoin and Ethereum protocols adhere to this principle.
In summary, the fundamental analysis is one of the ways of seeing the market, focused on the essential aspects of the asset; however, they do not show the whole picture.
