Despite the cryptocurrency industry’s rapid growth in recent years, cryptocurrencies are still widely classified as high-risk investments because of their volatile nature. High risk isn’t necessarily bad or good for an investor. Risk can work both ways, meaning that each investment into crypto carries the risk of losing it all and the potential for generating life-changing wealth.
How do you determine whether the reward outweighs the risk for a given investment into a crypto asset? One of the most popular and effective strategies is fundamental analysis – a tried-and-tested method for improving financial success in the cryptocurrency market. The following article will explore what fundamental analysis is and how it can be used to gain an edge on the market.
What is Fundamental Analysis?
Crypto fundamental analysis involves thoroughly analyzing the available information about a crypto asset. The objective of fundamental analysis is to reach a conclusion on whether the crypto asset is undervalued or overvalued. Investors can then use these conclusions to strategically enter or exit crypto positions.
A fundamental analysis strategy is essential to the success of traders and investors. Fundamental analysis can help long-term investors identify undervalued projects amid extremely volatile market conditions. It also allows traders, whether seasoned or non-technical traders, to trade with confidence.
How is Crypto Fundamental Analysis Different?
Analyzing cryptocurrencies differs significantly from analyzing traditional businesses. Unlike fundamental analysis for equities, which entails using financial statements to examine a company’s financial health, cryptocurrencies have no financial statements. Instead, the more decentralized crypto assets such as Bitcoin, are closer to commodities, meaning a new framework is needed.
Cryptocurrency fundamental analysis employs quantitative and qualitative fundamentals, which are commonly grouped into three categories:
- Financial metrics
- On-chain metrics (also referred to as blockchain metrics)
- Project metrics
In the following sections, these three categories will be discussed along with their respective metrics. Note while the subsequent metrics will provide you with a robust foundation, they are non-exhaustive.
Best On-Chain Metrics for Fundamental Analysis
On-chain metrics are those that can be observed by looking at data provided by a blockchain. For those that need a refresher, a blockchain is a system of recording information in a way that makes it difficult to change, hack or cheat the system. On-chain metrics can expose details about an asset’s behaviors and the processes and technology that allow them to happen.
Application programming interfaces (API) are used to extract information from the blockchain’s raw data. It is extremely time-consuming and expensive to manually extract raw data from the blockchain.
Three of the most important elements to take into account when analyzing a cryptocurrency using on-chain metrics are as follows:
Active Addresses
Active addresses refer to blockchain addresses that are active in a given period of time. While approaches to calculating this metric vary, a popular method is to count the receivers and senders of each transaction over set periods (e.g., days, weeks or months).
Active addresses are an effective way to assess the health of a blockchain network. This metric shows network growth and contraction across time. Interestingly, active addresses often follow the rules of supply and demand. If demand rises while supply remains the same, the price will increase. Similarly, if a network experiences an increase in daily active addresses, the price of the particular coin could also increase.
Transaction Values
The transaction value measures how much value has been transacted within a specific period of time. For instance, if a total of 20 Ethereum transactions, worth $50 each, were sent on the same day, then the daily transaction volume would be $1,000. Transaction value can be measured in a fiat currency like USD; however, it can also be measured in the protocol’s native unit.
Overall, the presence of a consistently high transaction value indicates that the cryptocurrency is in regular circulation – a sign of a healthy network.
Hash Rate
Unlike the traditional banking system, for most cryptocurrencies, the issuance of new coins is not in the hands of centralized entities. Instead, specific blockchains (referred to as proof of work blockchains) generate new cryptocurrencies through the process of mining, which is the process through which cryptocurrency transactions are verified, gathered and recorded in a digital public ledger known as the blockchain, with Bitcoin being the most prominent example.
Hash rate measures the ability of miners to conduct mining (hashing computations) effectively and efficiently. The hash rate is directly proportional to a miner's or mining pool's profitability.
Hash rate is used as a measure of network health in proof-of-work cryptocurrencies. It serves as an indicator of the overall security of a blockchain network, as well as the mining difficulty for miners to earn block rewards. The likelihood of a malicious attack on the network decreases as the hash rate increases and more miners join a blockchain network to compete to mine blocks.
Best Financial Metrics for Fundamental Analysis
Financial metrics encompass data on currently traded assets, including the price at which it traded previously, external variables, liquidity and market reaction. Some of the most important financial metrics include:
Market Capitalization (Market Cap)
Market capitalization is calculated by multiplying the total circulating supply of coins by the current market price of a single coin. It measures the total value of a cryptocurrency on the open market and can be useful for determining growth potential.
Market capitalization is useful for estimating the growth potential of networks. Some investors consider small-cap projects to be more likely to grow compared to large-cap ones. It takes less buying volume to increase their price, meaning that investors can benefit from more explosive growth. Conversely, others believe large caps have stronger network effects, and therefore, have a better chance than unestablished small caps of achieving sustainable growth in the long term.
Supply Mechanisms
Supply mechanisms are a versatile metric that creates interesting properties from an investment perspective. For example, models like the Stock-to-Flow (S2F) ratio are growing in popularity within the Bitcoin community.
Circulating supply, maximum supply and rate of inflation are a few factors that can inform decision-making. Some coins produce fewer new units over time, which appeals to investors who think the demand for new units will outstrip their availability in the future. Alternatively, other investors believe rigid supplies are dangerous in the long-run, thereby disincentivizing adoption and incentivizing users to hoard them.
Liquidity and Volume
Liquidity is the lifeblood of all tradable assets, including cryptocurrency. It refers to the ease with which a coin can be converted into cash or other coins without compromising its value. Cryptocurrencies that are difficult to exchange for cash or other digital assets are considered illiquid assets, while ones that can be converted right away are considered liquid assets.
Conversely, volume refers to the number of cryptocurrencies traded in a single market during a specific period of time. A higher trading volume highlights a greater overall market interest in a particular cryptocurrency.
Best Project Metrics for Fundamental Analysis
Project metrics are a qualitative approach that examines factors such as the whitepaper and the development team, competitors and a crypto project’s tokenomics and utility.
The Whitepaper
It is best practice to – at the minimum – read the whitepaper of any crypto project before investing. The whitepaper is a technical document that provides an overview of the aims and dynamics of the cryptocurrency project. Ideally, a strong whitepaper should elucidate the goals of the network and provide insight into:
- The use cases(s) it aims to achieve
- The roadmap for future upgrades and new features
- The distribution scheme and supply for coins or tokens
- The technology used
Prudent investors will cross-reference information obtained from the whitepaper with information from secondary research. Try to see if you can find red flags or identify unrealistic goals.
Tokenomics and Utility
Tokenomics refer to the economics of the token demand and supply. Tokenomics is fundamental to cryptocurrency because it drives price and value. Tokenomics is a complex subject area that involves incentive structures used to motivate behavior in a crypto ecosystem. Investors should analyze the tokenomics of a cryptocurrency to assess risks and determine whether the ecosystem can sustainably grow in the long term.
Utility refers to the role a token or crypto can play in the real world. Projects with more or stronger real-world use cases have an increased likelihood of attracting more users and attention.
Competitor Comparison
Analysis of competitors is essential for developing a good understanding of industry hierarchy. Market competition separates winners and losers. Detailed research into the landscape can allow you to hand-pick projects that are better positioned to succeed compared to their competitors in the sector.
Best Fundamental Analysis Tools
Fundamental analysis tools give investors a bigger picture of what’s going on in the crypto markets. Investors can expect to identify large trends and be able to differentiate valuable tokens from those with low potential. Here are useful two tools for fundamental traders:
CryptoQuant
CryptoQuant is one of the leading on-chain analysis tools in the cryptocurrency sector. On-chain analysis involves examining information from a blockchain ledger to determine market sentiment and predict future price movements. CryptoQuant helps investors analyze crypto markets and find data-driven opportunities to reduce investment risk.
Messari
Messari is a cryptocurrency data aggregator that empowers investors to make better trading decisions. It has a screener with a variety of filters, such as price, market cap and sector, in addition to comprehensive analytical profiles of a variety of cryptocurrencies.
Where to Buy Cryptocurrency
Major cryptocurrencies such as BTC can be traded on major exchanges such as eToro, WeBull, Uphold and Gemini. Many of these platforms allow you to purchase Bitcoin using your credit card, through swapping features or through different trading pairs such as BTC/USDT.
Cryptocurrency is offered by eToro USA LLC (“the MSB”) (NMLS: 1769299) and is not FDIC or SIPC insured. Investing involves risk
Don’t invest unless you’re prepared to lose all the money you invest. This is a high-risk investment and you should not expect to be protected if something goes wrong. Take 2 mins to learn more
Terms Apply. Cryptoassets are highly volatile. Your capital is at risk.
So is Fundamental Analysis Worth it?
Crypto fundamental analysis is a great way to enhance your performance in the cryptocurrency market. Before allocating money to a particular cryptocurrency project, consider analyzing a few of the metrics mentioned above. Fundamental analysis in combination with a broader analysis of the aggregate crypto market or financial market will further mitigate risk and help you develop a more accurate understanding of whether a cryptocurrency is undervalued or overvalued.
However, it is important to note that even the most diligent fundamental analysis does not guarantee success nor is any of the guidance in this article financial advice. The high-risk nature of cryptocurrencies and uncertainty regarding government regulation makes investing in cryptocurrencies inappropriate for the faint of heart. Prudent investors will only invest money they can afford to lose.
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