Q: Is it a good time to invest in Ripple?
A1: Oh no, they are not true to the basic idea that blockchains aim to establish, i.e. decentralization! I will not support such an attempt to haul us back to the dark ages!
A2: OMFG NO, look at the large number of coins in circulation. It already has a market cap of $ 43.77 bn, it has no upside!
Now I have heard these lines of reasoning for a longtime, there are people who obsess over decentralization and then there are those who raise a hue and cry over the market cap. But if you ask me, I don’t really understand what all the fuss is all about. I can’t complain about those who cry about the decentralization part, though I am more loyal to increasing my gains rather than being the knight in shining armor for a technology!
But the second set of people are those whom this article is targeting! The keyword here is the ‘MARKET CAP’ short for ‘MARKET CAPITALIZATION’.
What is the market cap? In the equity markets market cap is the product of the number of shares outstanding in the market and the market price of each share.
So if a company has 10 outstanding shares, and each share costs $ 20. Then the market cap will be $ 200 in whatever unit is relevant.
Thus, if we just extend the logic, the market cap for any crypto currency would be the product of the number of tokens in circulation and the price of each token! Right?
Wrong! Well this is one of the rare cases where you are not wrong yet you are wrong. The problem here is the remnants of the equity investor inside us.
What is the market cap really?
It is the total valuation of the company!
What is it used for?
As we said earlier we use it to value the company. So if one wants to buy a company, he/she will have to shell out an amount that is equivalent to the market cap (and possible a premium as goodwill).
But now if you do not know about how the market cap is calculated in greater detail for predictive analysis, let me give you an idea from the finance perspective. The company’s Estimated Earnings per Share (EPS) is calculated based on the company’s projections. The company’s marketing and sales team come together to decide how much it can manage to sell the coming year and hence how much will be the Net Profit. Broker houses have analysts who do the exact same thing, these analysts are industry experts, and they too invite over many knowledgeable players from the industry to make their own estimates. Thus the company or the brokerage house who is issuing the estimated EPS figures, manage to reach a well-researched prediction.
EPS = Net Profit / No. Of Shares Outstanding (Equation 1)
Now what is the lowest you should be willing to pay for the shares of a company?
It should be equal to the EPS. Eg: If a company is expected to earn INR 10 per share with a high degree of certainty. An investor should be willing to pay atleast that much! That becomes the minimum price of a share.
Now say a $ 10/share is a great return in the present market scenario. (I.e all the other companies are showing results that are way worse). Then due to lack of alternatives, investors will be willing to pay more than that $ 10 for that share because, hey, where else are you going to put it?
Now this increases to beyond a point and the number of times that we go becomes the PE, i.e., say investors are ready to pay $ 20 for that $ 10 EPS share, then the PE becomes 2, so an investor is willing to pay 2 times the earnings of a company. Now this $ 20 can be anything, based on how the investor perceives the company, if he has a lot of faith in the company then he might give more.
Eventually: PE = Market Price / EPS
Or, EPS * PE = Market Price
So this is the relation, and now if we multiply the number of shares outstanding to both sides of the equation we get:
Net Profit * PE = Market Cap (If you don’t understand what happened refer equation 1)
Why did I tell you all this?
Because market cap, at the end of the day is a measure of 2 things:
1. The net profit of the company, the %age of which you are slated to receive, because of you holding shares of that company
2. The voting powers of the company, again, the %age of which you are slated to receive, because of you holding shares of that company
Coming back to crypto:
In cryptos, you receive nothing, neither do you receive a %age of the earnings that the company who makes the coin receives. Nor are you getting any voting powers! So what good is the market cap?
In cryptocurrencies, the price is purely a function of demand supply! Market cap is meaningless!
Case for Ripple:
Ripple has a large number of coins in circulation, but its price is just a function of the demand. We know that the owners of Ripple have put their portion of XRP in a cryptographic escrow, and each month 1 bn of the total 100 bn will come out of that escrow, and we can buy it. So if suddenly there is a spike in demand, and that 1 bn XRP gets absorbed, then XRP supply will fall short of the demand resulting in an increase in price. And here the clients are banks, I won’t be surprised if they start buying up XRP in large numbers.
The remittance market for which XRP aims to be the bridge currency is worth $ 500 bn. So even if all the XRPs come into circulation, and XRP captures 100% of the market, each XRP has to amount to $ 5.00. And the remittance market is only increasing with time while all the XRPs are not coming into circulation anytime soon.
So my answer to all the Market Cap theorists out there is, don’t worry about it. In our crypto context, we cannot use the same finance terms without properly scrutinizing it. The reason why we buy shares is distinct from the reason we buy crypto.
We buy shares because we believe that a company will do well and give stellar returns to the investors. And on this fact the share price depends. (Ofcourse demand and supply play a part in this too, but this is the primary reason that triggers demand and supply)
In case of crypto, we buy it hoping that the technology is adopted by many people, leading to a spike in demand, so that the market players become willing to pay more and more for the same coin. There is no inherent justification for a market cap. It is not a multiple of the Net Profit. It is rather, a multiple of the degree of adoption. Just because a crypto has a high market cap, it doesn’t mean that they can’t go higher.
The biggest point to understand is that it doesn’t take much to change the market cap. If suddenly I and a few friends decide to execute a pump in the equity market, and the PE ratio increases to beyond a point, all the other market players will begin to short the stock, knowing that it is overvalued.
But there is no similar metric in the crypto world to check for overvaluation. So if me and a few friends pump and say buy and sell XRPs with each other for a value of $ 100 per XRP, then all the participants will spook, and start buying up XRPs left right and center. The exchange will assume that the last traded price of XRP i.e. $ 100 is the real value of XRP, and suddenly you will get a market cap of $ 100 * 100 bn = 10,000 bn (considering full supply of XRP) while in realty no money has changed hands, it’s just me and a friend, sending each other back and forth an XRP for $ 100.
Takeaway: Don’t look at the market cap and assume that there has been a huge amount of investment in a particular crypto, in the crypto world, there is no way to check if the market cap (or whatever you decide to call that number) is genuine.