Why Market Cap is a Meaningless & Dangerous Valuation Metric in Crypto Markets
Despite its foolishness there for all to see, market cap is blindly used by the masses and even experienced investors who should know better.
Much like the traditional stock market, the crypto asset market overflows with people who invest money in a state of mind-boggling ignorance.
In some cases driven by cynical greed and almost always by a sheep-like mentality and sublime inability to question established concepts, investors, both newbies and even those considered “astute” with millions of followers and dollars under management, have been reduced to delusion on an industrial scale.
Market cap or market capitalization is a calculation that emerged from traditional finance but one that has also seeped into the crypto world. It’s used everywhere as a justification for investment decisions and a metric to measure the size and value of a cryptocurrency or token.
But there’s a big problem.
Market cap is meaningless, easily manipulated, and creates a false sense of value. It’s actually even more than this. It’s downright dangerous because it misleads investors and plays a role in the crypto panics and wild swings that so often impact the space.
The continued proliferation of the term speaks to a reality of investor laziness. Most investors require a simple way of finding an answer to what is a very complex subject — the value of a network. It also speaks to the greed of some investors who use it cynically and the media’s insatiable appetite for sensationalist headlines.
How is market cap calculated for cryptocurrencies and tokens?
Market cap or market capitalization is calculated by multiplying the circulating supply of a cryptocurrency or token by its last transaction price. It’s a widely used metric for measuring the size and value of a cryptocurrency or token network.
It’s a simple calculation, which is perhaps why it’s so widely used. However, the real question is, what can it be used for? What does it mean? The Answer, ABSOLUTELY NOTHING. Here’s why.
Market cap doesn’t = value
It’s essential to find out what a company or asset you are investing in is worth when making an investment. If you understand what something is worth (its value), it’s possible to judge whether an investment is over or underpriced.
Herein lies the problem. Market cap is about price, not value. It does not reflect the value of the company or crypto asset you’re investing in. This is a fundamental distinction that is often overlooked. Price is what you pay for a coin or token, it has nothing to do with what you actually get aka value. It’s an indication of what people are paying for something, and this is usually driven by irrational sentiment, which has little connection to an asset’s real value. Assuming that whatever the market is willing to charge for an asset is equal to what it’s worth is a big mistake.
Think about the gains experienced by crypto assets in the last few years. Sometimes overnight, Bitcoin or Ethereum has added billions to its market cap. But what actually changed? Did they get more users, launch a new technology, or achieve more mainstream adoption? What change/s occurred to the underlying fundamentals?
All that happened was more investors were willing to pay a higher price. In the vast majority of cases, no underlying value was added to these assets, just more sheep willing to pay higher prices, which resulted in the market cap skyrocketing. As the market cap skyrockets, more sheep mistakenly believe the asset to have increasing value, and the cycle continues.
The critical takeaway. Market cap is about price, and the price has NOTHING to do with value. It’s just a multiplication of the last transaction price by the circulating supply, and, therefore, has no use when trying to assess value.
Market cap only reflects the last transaction price
The market cap of a cryptocurrency or token is about price, not value, which misleads many investors. But it’s more than that. Market cap only reflects the last transaction price multiplied by the circulating supply.
When you compute this, all you’re doing is multiplying the price that the last purchaser paid by the circulating supply, which gives you an irrelevant number with no meaning. The price of the latest transaction ceases to exist as soon as it is completed, all previous transactions have a different price and those made right after will be priced differently as well.
In other words, the outcome of the market cap calculation applies to a specific moment in time. Yet it assumes all sellers, buyers, and even all holders, including those that aren’t selling or buying, are at the last transaction price. To calculate market cap, a pointless task anyway, you’d have to calculate what everyone who has ever invested actually paid and total it all up. But even this would be inaccurate and misleading because of issues with circulating supply.
Circulating supply is over accounted
Circulating supply has several issues that impact market cap. Coin-Market-Cap defines circulating supply as:
“the best approximation of the number of coins that are circulating in the market and in the general public’s hands.”
This is an oversimplification and misleading for investors. The problem is that it’s hard to tell how much of a coin or token’s supply is available for trading at any given time. Sites like Coin-Market-Cap do not exclude lost coins from the circulating supply count because there is no way to know how many are lost.
Take Bitcoin, for example. It’s estimated there are approximately 3 to 4 million lost Bitcoins. If these get taken into account, the circulating supply of Bitcoin wouldn’t be the 17,425,512 BTC at the time of this writing, but rather around 13.5 to 14 million, which would reduce the market cap considerably. Furthermore, the circulating supply doesn’t take into account illiquid coins or tokens in long-term storage. Much of the current Bitcoin supply is made up of bitcoins that have been inactive for more than a year.
Market cap doesn’t represent real money invested
Market cap does not represent how much money has been pumped into a coin or token. In fact, this could not be further from the truth. If, for example, a market cap rises or falls by $100 million, it doesn’t mean $100 million has entered or exited from the asset.
Let’s say I create a token with a 10 billion supply, I develop a simple ERC20 contract and deploy it on Ethereum, and on an exchange. I then convince my friend to buy one of these tokens for $1. Boom there you have it. A token with a $10 billion market cap. Congratulations to me! I have now created a promising new project that has received lots of investment.
As you can see, this is all absolute rubbish. It doesn’t mean $10 billion was invested in my token, and it in no way helps in understanding its value. Market cap only serves to obscure and create a false sense of value when actually it’s just a multiplication of the last transaction price by the circulating supply.
If I take this example even further. Let’s say my friend turns around and sells the token I made for $2 to someone else. The market cap would go from 10 billion to 20 billion, even though only $2 has changed hands. So, if you see a token with a $1 billion market cap, it may have only $10 or $20 million invested in it. If it collapsed and went to zero, investors would only lose $10 or $20 million, not $1 billion.
“Market cap created the perfect tool to attract newbies by artificially inflating the numbers. They mine 1 million coins they release a thousand in reality which they can buy for 10$ a piece. And suddenly that crapcoin has a 10 million market cap and noobs flock. And in one week time, most of them get fleeced.” — Unknown
The bottom line. Crypto assets with a low float and high total supply can game the system and make themselves look valuable. Market cap and changes in market cap are meaningless and deceiving.
Market cap is a useless comparison tool
Measuring one coin or token’s market cap with that of another is a meaningless excersize. All that is achieved is a comparison of what the last person paid multiplied by the circulating supply of each. The number deduced from this calculation delivers no actionable or useful insight.
Furthermore, even if the market cap of a coin equaled its value, comparing them would still be pointless because each coin or token is different and should be measured differently. Investors often say things like, “X coin has a market cap of $1 million while Bitcoin has a cap of $57 billion, so X coin is undervalued and a great investment opportunity.” Or X coin has a market cap of $1 million compared to Bitcoin or Ethereum. Thus they are overpriced and due for a decline.” Or” X Coin could never have a market cap of $100 billion, Bitcoin’s is only $57 million.”
This is all pointless, and here’s a question that is rarely asked. Why has Bitcoin been assigned a god-like market cap that no other crypto can ever surpass? To sum up. Market cap is meaningless. But even if it weren’t, the market cap of one coin, be it Bitcoin, Ether, Ripple, or some altcoin has nothing to with the market cap of any other whatsoever. Crypto assets are designed for different market segments, users, and purposes and so comparing their market caps is stupid.
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Originally published at Blockchain Review.