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Successful crypto investing requires a solid framework for value-based decisions. The efficient-market hypothesis suggests that prices already include all the information that is available about an asset, and that prices reflect the perfect value.

However, there are thousands of examples in crypto and stock markets to contradict this theory. The reality is that markets are inefficient. Why did Apple’s stock price decline by 30% in during the Covid-19 crash in February 2020? Did Apple sell 30% fewer products? Did Apple earn 30% less? Why did GAP’s stock crash 70% over 49 days? Did the biggest clothing retailer in the United States suddenly sell 70% fewer clothes?

The answer to all these questions is a resounding “No.” Markets are often irrational, and prices will not reflect value. As Warren Buffett said, “Mr. Market is a drunken psycho.”

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This is where the concept of value investing comes from. Value investing tries to identify securities that are underpriced due to market irrationality. These securities are trading below market value (i.e., with a margin of safety), and investors who buy them, hope that one day, the price will reflect the value of the stock. Quoting the greatest investor Warren Buffett of all time again: “Price is what you pay, value is what you get.”

The same happens with crypto assets. Bitcoin’s (BTC) price fell 50% during the Covid-19 crash in March 2020 — only to recover to previous levels 55 days later and double its price in the subsequent five months. Did these movements in price accurately represent the real value of the network, its activity, active wallets, transaction volume, and network usefulness? Did the prices reflect the value?

The answer is no. The trick is having the right tools to spot these opportunities — tools like fundamental analysis.

Fundamental analysis enables traditional institutional investors to understand the industry, attracting more capital and giving rise to more unicorns, similar to what happened in the internet and consumer industries. These core techniques are also becoming increasingly standard for retail investors looking for the highest-potential investments across a long-term investment horizon.

Hype versus growth, price versus value

There are a few axioms that are very important to any asset, including crypto assets. And although crypto assets are a relatively new asset class, they inherit similar core principles:

Most crypto assets represent an underlying network, utility, or community, built on some spectrum of decentralization. The market forever swings between bull sentiment and bear sentiment, between greed and fear, between unsustainable optimism and unjustified pessimism. Valuation methods are important to maintain a rational investment strategy.The future performance of an investment is a function of its present price compared to its fundamental valuation.It is possible to minimize risks by avoiding overpaying for overhyped projects by looking at their valuation metrics — rather than their prices.

So what’s the difference between prices and value?

Prices are the result of many other variables that often differ from the value: sentiment, market hype or depression, speculation, fear, greed, overinflated news, etc. All assets have a non-negligible percentage of irrationalism, but crypto sometimes suffers from this disorder to a higher degree — especially recently in the memecoins sector. Specifically, there are many factors that can influence cryptocurrency prices, including market demand, market sentiment, government policies, regulatory changes, technological innovations, industry partnerships, project progress, and so on.

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Valuation refers specifically to determining an asset’s financial value. Valuation involves analyzing data to determine the intrinsic value of an asset using fundamental analysis. As the industry gradually matures, we are discovering that traditional financial valuation methods can help push past the hype to identify the projects with sustainable growth potential — whether due to being undervalued by the market or due to the size of the yet-to-be-tapped market opportunities.

A framework for crypto valuation

Given the diversity of crypto assets in the market, there’s no “one-size-fits-all” valuation method. Investors need to look at different options and see which best fits each specific case. The first step is to categorize the asset. Is it a nonfungible token (NFT)? A payment token? A utility token? Or something else? (After all, unlike securities, cryptocurrencies and tokens have a wide range of purposes and utility and give investors different rights.)

For a native cryptocurrency — such as Bitcoin — you could, for instance, use Metcalfe's Law. You could use the same method on a layer-1, such as Ethereum (ETH), or you could opt for something else, such as a stock-to-flow model.

Once you’ve categorized the token, use an analysis of your choice — one of those referenced above, or a different one from the image below.

Long-term successful investing in crypto doesn’t require an unusual IQ, special business insights, or insider information. You only need a solid framework for making investment decisions that is based on value rather than speculation. Happy investing!

This column was excerpted from "Digital Asset Valuation Framework," published by HashKey Capital in April 2024.

Jupiter Zheng is a partner of liquid funds and research at HashKey Capital, a financial services firm with offices in Tokyo and Singapore. He served previously as the deputy head of Zhongtai Financial's FinTech Department and as a senior associate in research at BOCOM International. He holds an undergraduate degree in applied physics from Beihang University and a graduate degree in operational research and business statistics from Hong Kong Baptist University.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts, and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.