Cryptocurrency Valuation: How to Understand Ripple And How To Value Ripple

Editor's Comment: With South Korea and China's real and alleged crackdown on Bitcoins as well as the broad cryptocurrency world, several other 'assets' such as Ripple are capturing popular imagination. Often treated synonymously with the former, Ripple has a different structure which makes it easier to view as a 'store of value.' A general lack of awareness of this crypto asset is suggestive of the overall frenzy of our times. Here's a look at how to value Ripple. 

 

Isaac Newton once said that he could calculate the motion of heavenly bodies but not the madness of people. Newton is believed to have lost almost all of his fortune during the South Sea bubble in the spring of 1720. Nothing epitomizes this more than the frenzy we are currently witnessing in the cryptocurrency space. In recent weeks, crypto ‘enthusiasts’ have turned their attention from Bitcoin to ‘cheaper’ assets such as Ripple, Stellar and Tron.

 

To begin with, Ripple is nothing like Bitcoin. Anybody who believes they are getting in on the next Bitcoin while buying Ripple are hugely mistaken. Ripple is not a cryptocurrency, rather a technology services provider, one which should ideally be listed on the NASDAQ. Another aspect often forgotten by enthusiasts is that in many senses, Ripple is not truly decentralized and has a strong control over its inner mechanisms.

 

Ripple uses a novel consensus algorithm to validate transactions. It requires computers to identify themselves and obtain permission to be able to participate in the currency’s network. This stands in stark contrast to Bitcoin, where any computer is allowed to join, without any authentication.

 

Unlike Bitcoin which relies on a network of “miners” running codes that validate transactions and keeps the currency secure - Ripple’s setup has no miners. All 100 billion coins of XRP (Ripple issued currency) that exist were created when the network was launched in 2012. Its creators kept 20 billion and gave the rest to the company.

 

Since then, Ripple has been “methodically” distributing tokens to clients, still holding 50 billion in an escrow account. To ensure long-term stability, Ripple announced the structured sale and use of its currency. Thus, ensuring that investors have some sense of what's in store and can be assured that there won’t be a supply shock leading to price capitulation.

 

Traders and investors should focus on the market capitalization of Ripple. A question they should ask themselves while buying Ripple is whether the prevailing market cap is rational, assuming the most bullish potential scenarios going forward.

 

Ripple has an end use case scenario providing us with a basic framework for its valuation. It aims to be a “bridge currency”, one that many financial institutions use to settle cross-border payments faster and cheaper when compared to global payment networks. Bitcoin could be used to the same effect, but Ripple can settle a thousand transactions per second, compared to Bitcoin’s seven, with much lower transactional costs.

 

This is Ripple’s ‘secret sauce’ and the reason why its management believes the currency’s true value is much higher. The company claims that more than 100 financial institutions are using its technology. But it remains to be seen just how seriously big banks and financial institutions use Ripple as a currency in itself.

 

Now let’s try to do a quick back of the envelope valuation for Ripple.

 

Assuming that the global daily foreign exchange volume is $5 trillion.

 

Suppose Ripple has 10% market share and moves around $500 billion a day, using the XRP network for major banks and financial institutions.

 

Considering it can capture 0.1% of the notional sum above as revenue, it amounts to $500 million of revenue per day. That is $15 billion a month and $180 billion a year of annual revenues.

 

Assuming no costs and using a simple (and generous) forward revenue based multiple of 2, one can value Ripple at $360 billion.

 

At Ripple’s current price of $2, its market cap stands at $80 billion. If one were to use the above framework (and the reader can tweak around with the numbers to arrive at his/her own fair value), one can arrive at a target price of above $8 which implies a 4x return.

 

Build your own models and frameworks before buying Ripple. Don’t buy it because it is available for $2 per unit. Remember there is a difference between price and value.