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[Shibe Market Analysis] An Introduction to Fundamentals-based Valuation

Browsing /dogecoin and the community at large, you may have noticed that typically people "value", or form an estimate of the prices they'd be willing to buy and sell dogecoin at, through a number of methods, most common of which are a buy and hold-style (which at its core is saying dogecoin will be undervalued til we reach the proverbial moon) and technical analysis based, akin to saying "dogecoin hasn't gone below 150 in a while, so buying at 150 is probably a good idea".
While both of these techniques have their merits, there is a 3rd methodology of valuation that may interest the more mathematically-oriented shibes, and is helpful for all shibes to be familiar with, namely fundamentals-based valuation.
What are fundamentals?
Fundamentals are the underlying characteristics of the doge economy; metrics like the average transaction value, network difficulty, block reward and rate of dogecoin production are all ways of "measuring" these characteristics and play a role in fundamentals-based valuation. It is worth noting that only fundamentals-based valuation can answer the question of "why", because it is the only methodology that incorporates the underlying economy beneath the price of doge. For example, if i ask why dogecoin doesn't go below 150, a trader may answer that whales have a buy wall at 150, or there is strong support at 150, but can never really explain why these phenomenon choose the price of 150 to assert themselves.
A Fundamentals-based Valuation
This spreadsheet shows the process of arriving at a target price for DOGE/BTC based on the underlying network difficulty and the cost of building a mining rig.
Modeling the rig
Mining rigs are a core component in the production of dogecoin, and while there are vast differences in their appearance and features, all mining rigs can be boiled down into two key metrics - the capital cost per kilohash per second, and the electrical consumption per kilohash per second. Capital cost per KH/s measures how much it costs to build the rig, and typically hovers around $1 per KH/s. Using quality parts and higher margins of safety pushes this value up, while skimping on quality and operating with smaller safety margins can push this value closer to $0.75 or lower. A lower value of capital cost per KH/s means your rig is more efficient with your capital (the money you use to build it). Electrical consumption per KH/s is much more standard, as the predominant AMD gpus essentially share the same chips, and so even though some cards generate higher KH/s, they also use more electricity. This number combined with the electrical cost per kWh in your region essentially determine your "operating cost", or the cost you pay to keep your rig running. I've used the typical electicity cost in my region, 15 cents per kWh.
As a side note, the primary feature of scrypt asics is not the fundamental revolution it was in bitcoins - scrypt asics simply offer much lower electrical consumption per KH/s in exchange for a much higher capital cost per KH/s. It remains to be seen whether the hardware manufacturing industry will reduce the cost of scrypt asics enough to make them competitive with GPUs on a capital cost per KH/s basis. If this happens, then they will indeed become the dominant form of mining hardware, otherwise there will always be room for GPU rigs.
Modeling the Macro Economy of Doge
The network difficulty parameter you've probably heard of before, and essentially controls how many doges you receive per KH/s over a period of time. Since the total number of doges given out per block must average out to a fixed rate, but the global hash rate changes, the network difficulty adjusts to distribute the doges proportionately.
Finally, the Daily Growth Rate is one of the most important parameters, and one of the hardest to estimate. Essentially it's the growth rate of the dogecoin economy, and different ways of estimating it will dramatically change the result. Historically over the last 2 months, the doge economy has grown at an average pace of 5.04% per day, measured by market cap.
Putting it together
Using the network difficulty, its possible to estimate the daily doge production per KH/s, which using a network difficulty of 1418 works out to be approximately 7.09 doges/day. The electricity used to produce this is a flat $0.000000625 worth of kWh per day. The capital cost, on the other hand, varies according to the interest rate you use. Since we're assuming 1 KH/s costs $1 of capital, the required interest you need to earn on your capital is the effective daily cost of capital. Summing the two costs gives you an estimated total cost per day in USD of producing the 7.09 doge, and from this we can derive an implied exchange rate.
As you can see, the primary driver of changes in this exchange rate is the interest/growth rate on capital - much like how in fiat markets, the interest rate on government bonds determines exchange rates (if I can earn 2.5% on bonds in India but can borrow at 0.25% in the USA, I will borrow USD to exchange into Indian rupees to buy their bonds and earn a 2.25% spread, and in doing so create demand for rupees and supply of dollars in exchange markets, pushing the value of the rupee up).
In the case of doge, you can think of it as you can borrow on your credit card for 35% annually, or approximately 0.082% daily, and then use the money you get to buy a rig, which earns you 1.65% per day, and pocket the difference of 1.56% (please do not max out your credit card doing this). Should the value of doge fall below the level corresponding to 0.082%, new miners no longer will want to take debt to build mining rigs. I haven't done the calculations here, but you can actually use litecoin in a similar manner - litecoin is a safer, more established crypto than doge with less price variation, and so at the same rate of return on capital, a miner will probably choose to mine litecoin. Implicitly this also means that mining doge must earn a higher return than mining litecoin, and so the rate of return on capital mining litecoin sets a floor for the rate of return of mining doge, and thus the price of doge. Should the price of doge hit this floor, rather than the price continuing to fall the global hash rate and difficulty would begin going down instead, and those miners continuing to mine doge would receive the required return on capital because they collect more doges per KH/s.
Takeaways
Examining the selected interest rates, you can see that at the historical average growth rate of 5.04%, doge should be worth 1024 satoshis, more than 5 times the current price. It's clear the market doesn't believe we will continue growing at 5.04% per day. Working backwards from the current exchange rate, we can actually see that the market currently estimates the doge economy to grow at .86% per day going forward. When the block reward halves, if the network difficulty doesn't fall substantially, dogecoin will need to become substantially more valuable in order to justify the capital used to mine it. In practice, it will probably be a combination of the network difficulty decreasing and the price of dogecoin increasing that re-equilibriates the market, but this process may go on for a few weeks during which time the price of dogecoin and the network difficulty may be highly volatile. Notably, the hash rate that leaves dogecoin will probably migrate to other cryptos, and so it may be worthwhile for daytraders and speculators to begin looking for those alt-coins likely to attract the displaced hashrate from dogecoin once the block reward halves, and buy those coins before their network difficulty rises in anticipation of the prices rising.
While this article isn't meant to be a definitive guide on fundamentals-based valuation, it is meant to introduce the concept and light the path for shibes more interested in investing for the long run and display some of the techniques and the frame of mind behind valuations based on the underlying economy, rather than the lines on a chart.
Happy trading shibes!
Disclaimer: I am not psychic and do not actually know where the market is going; I'm pretty sure the market doesn't know where its going either (except TO THE MOON!). Please do not base your trading decisions solely on the above analysis, and never trade more than you're comfortable losing. Finally, please do not hate/sue me if trades don't go your way, but if they do go your way, it was totally because you read this article :)
If you're looking to learn how to trade or just want a quick refresher, check out my ongoing series, or if you just want to subscribe to these market analyses check out DogeTrader.
submitted by kwickymartkidd to dogecoin [link] [comments]

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