A look at the traditional approach to analysing stock prices and why it doesn’t work for cryptocurrencies.

Summary:

A Discounted Cash Flow (DCF) model and Price-to-Earnings (P/E) ratio are two key ways to evaluate the value of stock prices.

These indicators only work in efficient markets.

When comparing the stock market to the cryptocurrency market, it’s clear that the cryptocurrency market is not efficient.

There’s no way traders can know how much a cryptocurrency will eventually be worth as they don’t have intrinsic value.

As the cryptocurrency market has had its rise and fall in recent years, traders have sought to understand how to properly trade this market. And while it may be logical to think that the models used to evaluate traditional stock prices could apply to cryptocurrency markets, this approach fails to recognise the fact that cryptocurrency markets aren’t efficient. In this article, we’re taking a look at how traders typically value stocks using Discounted Cash Flow (DCF) models and the Price-to-Earnings (P/E) ratio of a company and why this approach doesn’t work for cryptocurrency.

What is a Discounted Cash Flow (DCF) Model?

A DCF model is a type of valuation method used to evaluate the value of stock prices. Using this model allows traders to estimate future free cash flow projections for a company. Once the amount of future cash flows is projected, a trader can discount them to determine the present value of a stock. This model of evaluation provides traders with a clear indication of whether a stock is over or undervalued giving a signal of whether to buy or sell.

Let’s take a look at Apple (AAPL) shares as an example. This DCF calculator indicates that fair value for Apple shares is $346.46. With Apple currently trading at $169.43 per share, this means that Apple shares are at fair value and it could be a good time to buy.

What is the Price-to-Earnings (P/E) ratio and what happens when investors’ expectations aren’t met?

Another way that people evaluate the value of stock prices is through calculating the P/E ratio of a company. The P/E ratio compares a company’s earnings per share with the current share price. This provides an indication of how much an investor needs to put into a company to collect $1 of earnings. For traders, this figure signals the strength of a company’s earnings and market expectations for the direction of the company’s stock price.

Using Apple as an example again, these calculations indicate that Apple has a P/E ratio of 14.01 as at 11 February 2019. With the current P/E ratio for the S&P500 sitting at 20.79, this indicates that Apple stocks have a P/E ratio below the current market average. What you can see here is that between the DCF calculation for Apple above and its P/E ratio, the numbers are slightly conflicting. This is because while a DCF model can estimate future cash flow, it’s not a definitive way to measure expectations around company performance.

The P/E ratio not only provides a leading indicator of market sentiment around a stock price, but it also allows any adjustments made in a company’s earning statement to be taken into more careful consideration than using a DCF valuation model alone. When investors’ expectations aren’t met as a company releases their earnings figures, this can cause a sell-off in a company’s stock. Conversely, if investors’ expectations are exceeded, a company’s stock price may rise. For traders, if a company misses earnings expectations, this can be a good time to sell while a good time to buy is when the company exceeds its earnings expectations.

The importance of recognising efficient markets

The DCF model and P/E ratio explained above provide traders with helpful tools to evaluate the value of stock prices. The big caveat here, it only works in efficient markets.

The efficient market hypothesis (EMH) is the theory that a company’s current share prices represent all of the information available and that consistently generating alpha is impossible. EMH also assumes that stocks are trading at fair value on all exchanges meaning that undervalued stocks wouldn’t exist and timing the market would not produce excess returns. While some could argue that the current stock markets are inefficient, the most current prime example of inefficient markets is the cryptocurrency market.

Why aren’t cryptocurrency markets efficient?

Based on the EMH detailed above, it’s clear that the cryptocurrency market is not efficient. Plagued by price manipulation and volatility, cryptocurrencies are starkly different from shares as they don’t produce free cash flow. This makes valuing cryptocurrencies and properly evaluating them for trading purposes risky at best.

The main reason why cryptocurrencies can’t be valued using the same methodology and theories applied to the stock market is that cryptocurrencies don’t have any intrinsic value. This means that while a company might have a sizeable valuation, cryptocurrencies don’t produce a product or service, generate revenue or employ people.

According to websites Coinopsy and DeadCoins, over 1,000 cryptocurrency projects had failed up to mid-2018. Some of these projects failed due to operational inefficiencies and the inability to launch what was promised in the ICO. Other cryptocurrency projects were scams from the outset. Take the BigONE Token for example. This project was founded in 2016 and doesn’t trade on any of the main cryptocurrency exchanges. The project was brought back with exchange earnings and declared a “dead coin” in 2018.

The key problem with evaluating cryptocurrency projects is the lack of transparency provided around future potential earnings and the project’s financial foundations. Unlike capital raising in traditional channels that requires a lengthy due diligence process, cryptocurrencies are still priced based on market hype. This has been evidenced by the all-time highs reached across multiple cryptocurrencies in late-2017 only for these values to decline rapidly shortly afterwards.

Conclusion

Cryptocurrency markets having a long way to go before they become a viable instrument to trade. Without the characteristics of the EMH, cryptocurrencies are priced with what the market is willing to pay even when tokens are severely overvalued. The volatility in cryptocurrencies also makes it harder to enter and exit a trade at your desired price.

Conversely, data points available from publicly traded companies allows traders to determine if a stock is overvalued and it’s level of future earnings potential. While no one can truly know what a company’s future cash flow will be, the ability to calculate the P/E ratio for a stock allows traders to measure their expectations and speculate accordingly — a stark difference to what has been happening in the cryptocurrency market.