Summary:
- Intrinsic value is a way to measure the worth of an asset, independent of its market price.
- The intrinsic value of a cryptocurrency can be determined by its utility, scarcity and technological application.
- While metrics such as transaction volume and total value locked (TVL) can be used to gauge a crypto project’s intrinsic value, these should not be used in isolation.
What Is Intrinsic Value?
Intrinsic value refers to the inherent value of an asset or its true value, as opposed to what the market is willing to pay for it. It is influenced by many things such as quality, rarity, utility, and demand. It is often used to price options and stocks/equities.
Intrinsic vs. Extrinsic Value
It’s important to understand the difference between intrinsic and extrinsic value. As aforementioned, intrinsic value is the true value of an asset. In other words, it is the value of an asset that is not influenced by outside factors. For example, the intrinsic value of gold is based on its properties, such as its scarcity and durability.
The extrinsic value of an asset, on the other hand, is determined by external factors such as the market’s perception of its value. As such, the extrinsic value of gold is what the market is willing to pay for it.
Does Money Have Intrinsic Value?
While the intrinsic value of fiat money may be seen as its purchasing power (what it can buy) and extrinsic value is its exchange rate, in reality, it has no intrinsic value.
Although it has some intrinsic properties, like being a store of value and a medium of exchange, its value ultimately comes from faith in the issuing government and not from anything intrinsic. This is especially the case with our fiat currency today, as opposed to coins made from precious metals, such as gold or silver.
How to Calculate Intrinsic Value
There are a few different ways to calculate intrinsic value. Each method has its advantages and disadvantages, so it’s important to understand the different intrinsic value formulas before choosing one.
Discounted Cash Flow Analysis
This method estimates the intrinsic value of an asset by discounting its future cash flows.
The DCF intrinsic value formula is:
=(CF1)/(1 + r)^1 + (CF2)/(1 + r)^2 + (CF3)/(1 + r)^3 + … + (CFn)/(1 + r)^n
Where:
CF = cash flow (CF1 is the cash flow in year one, CFn is the cash flow in year n)
r = discount rate
n = number of years
There are three main steps in using the DCF Analysis when calculating intrinsic value:
- Estimating future cash flows: This involves estimating the future cash flows that the asset will generate.
- Discounting the cash flows: This involves using a discount rate to adjust the future cash flows for the time value of money. This means finding the present value of the future cash flows.
- Summing the discounted cash flows: This gives the asset’s intrinsic value.
To estimate future cash flows, you need to forecast the asset’s revenue and expenses over time. This can be difficult, especially for assets that don’t generate regular cash flows, such as stocks.
Once you’ve estimated the future cash flows, you need to discount them to the present. This is because money today is worth more than money in the future. The discount rate is usually the weighted average cost of capital (WACC), which considers the cost of equity and debt.
After discounting the cash flows, you need to sum them up to get the intrinsic value. This intrinsic value formula is sometimes called the Discounted Cash Flow Valuation model.
Gordon Growth Model or Dividend Discount Model
The GGM estimates intrinsic value by discounting the future dividend payments of a stock.
The GGM intrinsic value formula is:
Intrinsic value = dividend per share / (discount rate – growth rate)
Where:
- dividend per share = the dividend paid by the stock each year (this information is usually available from the company’s financial statements)
- discount rate = the required rate of return of the stock – can be estimated using the Capital Asset Pricing Model (CAPM).
- growth rate = the long-term growth rate of dividends
The GGM is a simplified version of the DCF intrinsic value formula. It assumes that the cash flows are dividends, and it doesn’t consider the company’s other expenses. It also assumes that the dividend growth rate is constant, which is not always the case.
Calculating the Intrinsic Value of an Option
The intrinsic value of an option is the difference between the strike price and the underlying asset price. The option’s strike price is the price at which you can buy or sell the underlying asset.
Intrinsic value formula of an option= (Stock price – strike price) x (Number of options)
For example, if a call option has a strike price of $50 and the underlying asset is trading at $55, then the intrinsic value of the option is $55 – $50 = $5
The intrinsic value of a put option is the intrinsic value of the underlying asset minus the option’s strike price. If the option is purchased at a premium, the intrinsic value is also reduced by the premium amount.
For example, if a put option has a strike price of $50 and the underlying asset is trading at $45, and the investor purchased the option for a premium of $7, then the intrinsic value of the option is $50 – $45 – $7 = -$2.
The intrinsic value of an option can be positive or negative. A positive intrinsic value means the option is in the money, i.e. if the owner exercised the option, they would be paying less than the current market value for a stock (for call options) or selling a stock for more than its current market value (for put options).
On the other hand, a negative intrinsic value means the option is out of the money and means that the owner will be paying more than current market value or selling for less than current market value.
As such, an option is only worth exercising if the intrinsic value is positive. This is because you can buy or sell the underlying asset for the same price as the option strike price. For example, if you have a call option with a strike price of $50 and the underlying asset is trading at $55, you would exercise the option because you can buy the asset for $50 and sell it immediately for $55.
Do Cryptocurrencies Have Intrinsic Value?
The intrinsic value of cryptocurrencies have been hotly debated ever since the creation of Bitcoin and till date, there is no definitive answer to the question of whether cryptocurrencies have intrinsic value. It can, however, be determined by several factors, including its utility, scarcity and technological application.
For example, Bitcoin’s intrinsic value comes from the fact that it is scarce (there will only ever be 21 million Bitcoins in existence) and has utility value (it has been proven to work as a P2P digital currency).
Another factor that influences the intrinsic value of cryptocurrencies is that they are not subject to the same rules and regulations as other assets, and may thus be viewed more favorably as an alternative investment. At the same time, this lack of regulation may also be perceived as a risk factor that negatively impacts the intrinsic value of cryptocurrencies.
How to Use Intrinsic Value in Crypto Trading?
While intrinsic value calculations for the stock market can be made by estimating future cash flows, the same cannot be easily done in crypto trading, as revenue structures and business models are completely different in the latter. As such, metrics such as transaction volume–which reflect market adoption, and total value locked (TVL)–which can be used as a proxy for liquidity and popularity, are more useful indicators to gauge the value of a crypto project or protocol.
For example, Ethereum has a TVL of $39.5 billion according to DeFi Llama, representing about 59.10% of the entire market share. A high TVL means that more capital is locked up in the ecosystem and users can therefore enjoy more yields and other benefits offered by protocols built on top of the blockchain.
At the same time, because money can easily move from one protocol to the next within the same ecosystem, there is a risk of double-counting, resulting in an embellishment of figures. At best, indicators like TVL provide an estimate of an asset’s value, and not a fail-proof metric. This is one reason why calculating the intrinsic value of a crypto can be trickier than that of a traditional stock.
An exception can be made in the case of tokenized assets i.e. digital assets that represent real physical assets such as real estate or gold. For example, the crypto token Pax Gold (PAXG) is backed 1:1 by one fine troy ounce (t oz) of a 400 oz London Good Delivery gold bar, so the intrinsic value of 1 PAXG is can be calculated as the market price of that corresponding gold bullion.
Conclusion
Cryptocurrency as an asset class is still in its infancy. In addition, no regulatory reporting standards have been established as yet for this sector. As such, traditional formulas of deriving the intrinsic value for a stock do not seem to have a direct application for crypto firms. The most important metrics of value are those that point toward adoption, growth and liquidity such as transaction volume and total value locked, although these also should not be used in isolation.
