Market Cap Analysis - Critical Tool to understand Cryptocurrency

Market Cap Analysis - Tool to understand Cryptocurrency

Market Caps are important for all markets regardless of size.  Generally this statistic is considered to be one of the simplest to understand but I have seen failures to understand it in a lot in cryptocurrency communities.  In particular Market Cap can be a misleading statistic in regards to large swings up or down when a market is not liquid.

The way a market cap  statistic works is pretty simple you take the total of something in existence and then multiply that number by its price / value.  According to Investopedia:
Market capitalization refers to the total dollar market value of a company's outstanding shares. Commonly referred to as "market cap," it is calculated by multiplying a company's shares outstanding by the current market price of one share. The investment community uses this figure to determine a company's size, as opposed to using sales or total asset figures.
Using market capitalization to show the size of a company is important because company size is a basic determinant of various characteristics in which investors are interested, including risk. It is also easy to calculate. A company with 20 million shares selling at $100 a share would have a market cap of $2 billion.

Read more: Market Capitalization

For a company that is exchanged on a major exchange this metric is a powerful  tool to view what the market is valuing it at.  Analysts will often compare market cap to their own valuation models and when there is a significant difference highlight an opportunity to either buy or short the underlying stock.

# of Asset x Asset Price on Market = Market Cap

 This method of analysis however is presuming that the market being used is fully liquid and vibrant, that there are buyers and sellers.  One can generally gauge a market vibrancy based off the statistic of volume.  When there are millions of things changing hands a day, it is relatively easy to trade in and out at a price close to the reported market price.  The lower the volume of the market the more this becomes less the case.

Consider the case of Action Comics #1.  Action Comics #1 was a comic printed in 1938 and is the first appearance of Super Man.  A pristine copy of Action Comics #1 sold on Ebay for $3.2 million dollars making it one of the most valuable comic books in existence.  Now no one is discounting the fact that Action Comics #1 is a highly valuable comic but......if you had another copy of the comic you could not immediately unload it on Ebay and expect to get the same high price at least instantly.  The reason is that the comic book market is not as efficient as the stock market.  There are not millions of Action Comics trading everyday.  If you want to sell 5 of them you would need to take time to ease them into the small market place in order to hope to capture that approximate value.

Consider a comic store who has 2 high quality Action Comics their market cap would rise significantly with the sell above, but then drop significantly if the next sale was lower.  You would see a wild swing in value of the comic store just for having 2 of these books.

The Cryptocurrency markets range from Bitcoin that is a fairly vibrant market (Though volumes are still generally lower than stocks on major exchanges) to very small markets that are more like that of comic books.

If you have a market where 10 things are changing hands a day and one sells for $1 and the next $10 dollars this could be reported as:

ABC Currency Holder has 10 million ABC Tokens.

Someone buys 1 ABC token for 10 dollars and previous market price was 1 dollar.

ABC Market Cap based on its Tokens had a market cap of $10 million and (10 million x $1 value) but now their market cap has risen by a factor of 10 and their market cap has risen an astonishing $100 million.  There is a great deal of hoorahs even though a measly 10 dollar transaction was made.

Then holders of ABC Tokens say hey I want to cash out at 10 dollars but find their are not enough buyers in the small market place to uphold that price and end up cashing out at 3 dollars.  Suddenly the market cap of ABC takes a massive hit and there is great gnashing of teeth sounds.  Even though another small amount of assets may have passed hands.

Market Cap drops while not telling the whole story should not be discounted though.  Either the price of the asset is viewed as being less valuable or the market it is trading on is weak.  The weakness of the market it trades in a variable in most asset valuation models.  A strong market is a positive thing and weak market is a bad thing.  It is for this reason that I consider down swings to be more meaningful than upswings.

This is the danger of small and illiquid markets.  A price is only as true as there are people willing to buy something at that price and small markets don't have the most reliable measures of price.  The true valuation of ABC in the example above in terms of a free cash flow model was likely entirely stable even though its market cap swung wildly.

Its for this reason why many Cryptocurrency investors are paying increasingly important attention to volume and # of transactions of the currency.  Currencies with a high volume are likely to trade at premiums from those that do not.  The weakness of Market Cap to tell the story does not mean that investors should shun it but should try to find other measures to temper their emotions and glean the true story.

--Crypto Kid

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