NVT Ratio Could Become New Gold Standard for Digital Currency Valuation

As digital assets further converge on mainstream consciousness, investors need to perform real due diligence and analysis instead of buying on ‘FOMO’ - the fear of missing out. The NVT Ratio may provide the new gold standard of digital currency valuation.In-depth analysis is still in its early days, yet there is clear momentum towards more academic processes. One valuation technique, the NVT ratio (Network Value to Transactions), is similar to a stalwart valuation measure of equities, the PE ratio.The NVT ratio is credited to Willy Woo, a digital currency data analyst and researcher.

What’s in the Ratio?

In valuing equities, investors use the PE ratio (price-to-earnings) to determine over or undervaluation. The PE ratio compares a company’s share price to its earnings per share, or, equivalently, market cap to the company’s total earnings.This is a measure of fundamental value for equities since earnings (present and future) are what equity investors are concerned with.For digital assets, the NVT ratio similarly uses a numerator that represents the price (market cap) of the network in question. To calculate the network value of a digital asset, multiple the price of an individual coin by the total number of coins currently in existence.

NVT and PE differences

Unlike the PE ratio, however, the NVT denominator does not represent earnings since digital currencies do not have earnings. Instead, the NVT ratio measures price against the utility or goal which investors seek in a cryptocurrency: namely, store of value and medium of exchange.As a proxy for how well the currency performs as a medium of exchange, analysts look at the volume of transactions on the blockchain in question during a 24 hour period. This speaks to the value proposition of being able to transact or transmit over a secure decentralized network. Bitcoin’s NVT, for example, divides the Network Value (USD) of $323 billion by the 24 hr BTC transaction volume on its blockchain (USD) of $5 billion, for a ratio of 64.6. The ratio is not normalized, and can be any positive number: unbounded on the high end, and bounded by 0 on the low end.

What does it mean?

Bitcoin’s NVT ratio compares how network value to how network use. Analysts posit that these should track each other closely. In the majority of cases, they do.The same way an equity investor wants a company with healthy earnings, a bitcoin holder wants the Bitcoin network to have a healthy amount of transaction activity. The reasoning is that as bitcoin use goes up, so should its value. When they deviate and one lags the other, there may be an opportunity for a trade.Investable insights come from analyzing the NVT ratio over time, and with a longer history, we can be more confident in knowing a healthy range. Bitcoin’s current NVT ratio sits around 64.6, which is firmly in the normal range since 2011.A high ratio, relative to its typical range, may mean that the future is bright and investors are expecting transaction growth, or it can mean overvaluation. Discerning between the two is the salient skill. Just like stocks, a high ratio is often seen in the early, high-growth stage: a network price is high, but transaction activity hasn’t yet caught up. Graph as of Dec 17, 2017. NVT Ratio in Red, Network Value in Yellow. http://charts.woobull.com/bitcoin-nvt-ratio/What matters is not only the absolute level of activity (or earnings), but expectations of future growth. The faster that transaction volume rises, or is expected to rise, the higher the NVT should be. The parallel is how tech (high-growth) companies have higher PE's than utilities (low-growth) companies. High ratios can thus be justified if there’s belief in future growth: such as Amazon having a PE of approximately 300, vs the S&P 500’s PE of 25.5.

Bubble detection

For many investing indicators, hindsight offers easy explanations. To truly be valuable, a metric must inform investors about value in advance, not after it’s too late. A leading indicator is more valuable than a confirming signal.As it stands, the NVT ratio can quite reliably help us decide what has happened after a price run up, but not before. Specifically, the ratio helps determine what follows a price run, consolidation or crash. It looks at whether the price increase is accompanied by an influx of network growth.According to the above graph, bubbles seem to appear around a NVT of 90-95. At this point, the market seems to think the value of the network is getting ahead of itself, and of its utility (transaction volume). One must be careful in drawing conclusions too soon, as the ratio can often move away from the periphery. A smoothed average is thus used to get a clearer signal through the volatile noise. You can see this past October, as the ratio approached 95, the price increase brought with it more transactional activity that pushed the NVT back down. In addition, you can compare the ratio vs other coins, although it should be vs peers that have similar utilities and properties.

Drawbacks

For all its merit, the NVT ratio still has two arenas of drawbacks: philosophical and practical. Regarding the philosophical or fundamental logic of the ratio, we are inherently assuming that the transaction value on the Bitcoin network is a proxy for what people care about. We are implying this is how Bitcoin derives its fundamental value or utility.Woo himself says that he came up with this ratio when pondering Bitcoin’s valuation compared to payment networks like PayPal: “If Bitcoin was a payment company, let’s measure how much throughput it has, to its valuation.”The thought of Bitcoin as a payment network is increasingly difficult to defend. Its use as a store of value and speculative investment are what currently excite people. However, Woo contends that the ratio still captures these other use cases, as transactions still must happen to store value and speculate.As a practical matter, the transaction data is sometimes unclear, as we want only on-chain volume, and don’t want volume that occurs on or between exchanges. The problem will be magnified when we have truly scalable payments, which may occur off-chain with solutions such as Lightning network for BTC and Raiden network for ETH.

Open playing field

For all the attention that Bitcoin and digital currencies garner, it's important to remember this is just the beginning of investing and trading with analytical rigour. Like traditional investment indicators, real value may come from comparing digital currencies against each other. The NVT ratio will be applicable to other coins and networks, but not necessary all of them. The value transmitted on-chain must represent network usage. Thus, Ethereum is a good candidate, but staking and privacy coins are not, as they have unstable volume.As market efficiency increases with more participants, derivatives, and academic research, investors will trade the asset class like any other. The NVT ratio provides a glimpse of the type of analysis, and acceptance, we can expect.Editor’s note: All calculations are for illustrative purposes only. They were made using available data at the time of writing.Image credit: picpedia.org

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