What Is Fundamental Analysis (FA)?
Fundamental analysis (FA) is to an investor what technical analysis is to a trader. Those focused on long-term value appreciation rather than short-term gains should look favorably to a system such as FA, as it teaches you to determine the fair value of a cryptocurrency.
In a market with more than 5,000 assets to choose from, picking the right one might look like a life-long quest. New tokens come and go, and there is never a way to tell which one can stand the test of time. One might think that investing in a cryptocurrency that is not Bitcoin or Ethereum is like betting on the lottery, but is that really the case?
In cryptocurrency fundamental analysis, though the approach is similar to that used in legacy markets, you can’t really use tried-and-tested tools to assess crypto assets. To conduct proper FA in cryptocurrencies, we need to understand where they derive value from.
In this article, we will attempt to identify metrics that can be used to craft your own indicators.
What is fundamental analysis?
Fundamental analysis is a method used by investors and traders to attempt to establish the intrinsic value of assets or businesses. To value these accurately, they’ll rigorously study internal and external factors to determine whether the asset or business in question is overvalued or undervalued. Their conclusions can then help to better formulate a strategy that will be more likely to yield good returns.
The end goal with this type of analysis is to generate an expected share price and to compare it with the current price. If the number is higher than the current price, you might conclude that it’s undervalued. If it’s lower than the market price, then you could assume that it’s presently overvalued. Armed with the data from your analysis, you can make informed decisions about whether to buy or sell that particular company’s stock.
Fundamental analysis (FA) vs. technical analysis (TA)
In fact, it might make more sense to question what each brings to the table. In essence, fundamental analysts believe that stock price is not necessarily indicative of the stock’s true value – an ideology that underpins their investment decisions.
Conversely, technical analysts believe that future price movement can be somewhat predicted from past price action and volume data. They don’t concern themselves with studying external factors, preferring instead to focus on price charts, patterns, and trends in markets. They aim to identify ideal points for entering and exiting positions.
Understandably, there is no objectively better strategy out of the pair, as both can present valuable insights into different areas. Some may lend themselves better to certain trading styles, and, in practice, many traders use a combination of both to observe the bigger picture. This is true for short-term trades as it is for long-term investments.
The problem with crypto fundamental analysis
So, we need to turn our attention to different frameworks. The first step in that process is to identify strong metrics. By strong, we mean ones that can’t easily be gamed. Twitter followers or Telegram/Reddit users are probably not good metrics, for example, as it’s easy to create fake accounts or buy engagement on social media.
Note that this metric should be treated with caution. As with active addresses, we can’t be sure that there isn’t just one party transferring funds between their own wallets to inflate the on-chain activity.
Active addresses are the blockchain addresses that are active in a given period. Approaches to calculating this vary, but a popular method is to count both the sender and receivers of each transaction over set periods (e.g., days, weeks, or months). Some also examine the number of unique addresses cumulatively, meaning that they track the total over time.
Because the cost to mine tends to increase over time, but the block subsidy is slowly reduced, it makes sense that transaction fees would need to rise. Otherwise, miners would operate at a loss and begin to drop off the network. This has a knock-on effect on the security of the chain.
Hash rate and the amount staked
Blockchains today use many different consensus algorithms, each with its own mechanisms. Given that these play such an integral role in securing the network, diving into the data surrounding them could prove valuable for fundamental analysis.
Factors that can influence the overall costs of mining include the current price of the asset, the number of transactions processed, and fees being paid, to name a few. Of course, the direct costs of mining (electricity, computing power) are also important considerations.
Where on-chain metrics are concerned with observable blockchain data, project metrics involve a qualitative approach, which looks to factors like the performance of the team (if any exists), the whitepaper, and the upcoming roadmap.
It’s highly recommended that you read the whitepaper of any project before investing. This is a technical document that gives us an overview of the cryptocurrency project. A good whitepaper should define the goals of the network, and ideally give us an insight into:
- The technology used (is it open source?)
- The use case(s) it aims to cater to
- The roadmap for upgrades and new features
- The supply and distribution scheme for coins or tokens
It’s wise to cross-reference this information with discussions of the project. What are other people saying about it? Are there any red flags raised? Do the goals seem realistic?
A strong whitepaper should give us an idea of the use case the crypto asset is targeting. At this stage, it’s important to identify the projects it’s competing with, as well as the legacy infrastructure it seeks to replace.
Ideally, fundamental analysis of these should be just as rigorous. An asset may look appealing by itself, but the same indicators applied to similar crypto assets could reveal ours to be weaker than the others.
Tokenomics and initial distribution
Information about how the asset currently trades, what it traded at previously, liquidity, etc. can all come in handy in fundamental analysis. However, other interesting metrics that might fall under this category are those that concern the economics and incentives of the crypto asset’s protocol.
By itself, market capitalization can be misleading. In theory, it would be easy to issue a useless token with a supply of ten million units. If just one of those tokens was traded for $1, then the market cap would be $10 million. This valuation is obviously distorted – without a strong value proposition, it’s unlikely that the wider market would be interested in the token.
Nonetheless, market capitalization is used extensively to figure out the growth potential of networks. Some crypto investors view “small-cap” coins to be more likely to grow compared to “large-cap” ones. Others believe large-caps to have stronger network effects, and, therefore, stand a better chance than unestablished small-caps.
Liquidity and volume
A problem we might encounter with an illiquid market is that we’re unable to sell our assets at a “fair” price. This tells us there are no buyers willing to make the trade, leaving us with two options: lower the ask or wait for liquidity to increase.
Being familiar with liquidity can be helpful in the context of fundamental analysis. Ultimately, it acts as an indicator of the market’s interest in a prospective investment.
Done correctly, fundamental analysis can provide invaluable insights into cryptocurrencies in a way that technical analysis cannot. Being able to separate the market price from the “true” value of a network is an excellent skill to have when trading. Of course, there are things that TA can tell us that can’t be predicted with FA. That’s why many traders use a combination of both these days.
As with many strategies, there’s no one-size-fits-all FA playbook.