How is Ripple valued: Here is a framework for valuing this ‘cryptocurrency’; everything you need to know

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Updated: January 14, 2018 1:01:29 PM

Isaac Newton once said that he could calculate the motion of heavenly bodies but not the madness of the people. Newton is believed to have lost almost all of his fortune during the South Sea bubble in the spring of 1720.

ripple, ripple framework, isaac newton, cryptocurrency, bitcoin, market, commodities, newton, newton policy, cryptos, what is bitcoin, what is cryptocurrencyAt Ripple’s current price of $2, its market cap stands at $80 bn. (Reuters)

Isaac Newton once said that he could calculate the motion of heavenly bodies but not the madness of the people. Newton is believed to have lost almost all of his fortune during the South Sea bubble in the spring of 1720. Nothing epitomizes the madness of people more than the frenzy we are witnessing in the cryptocurrency space currently. In recent weeks, crypto ’enthusiasts’ have turned their attention into ‘cheaper’ assets such as Ripple, Stellar, Tron and a host of other cryptos. Firstly, Ripple is nothing like bitcoin. Anybody who believes they are getting in on the next Bitcoin when buying Ripple are hugely mistaken. Ripple is not a cryptocurrency and should rather be viewed as a technology services provider which should ideally be listed on NASDAQ. Another aspect which Ripple enthusiasts forget is that in many senses, Ripple is not truly decentralized and has a strong control over its inner workings. Ripple uses a novel consensus algorithm (PDF) to validate transactions, and it requires computers to identify themselves and obtain permission to participate in the currency’s network. This stands in stark contrast to Bitcoin, where any computer is allowed to join.

Unlike Bitcoin which relies on a network of “miners” running code that validates transactions and keeps the currency secure, Ripple’s setup has no miners. All 100 billion coins of XRP that exist were created when the network 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, but it still holds 50 Billion in an escrow account. To create some long-term stability and ease those concerns, Ripple announced the structured sale and use of its currency. Thus, investors will have some sense of what’s coming and can be assured that there won’t be a supply shock that can lead to price capitulation.

Traders and investors should focus on the market capitalization of Ripple. The question they should ask themselves while buying Ripple is whether the prevailing market cap is rational assuming even the most bullish potential scenarios going forward. Ripple has an end use case scenario which provided us with a basic framework for its valuation. Ripple aims to be a “bridge currency” that many financial institutions use to settle cross-border payments faster and more cheaply than they do now using global payment networks, which can be slow and involve multiple middlemen. Bitcoin could be used to do this too, but Ripple can settle 1,000 transactions per second, compared with Bitcoin’s seven, and its transaction fees are much lower.

This is Ripple’s so called ‘secret sauce’ and the reason why its management believes the currency’s true value is much higher. The company says 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 itself. Now let’s try to do a quick back of the envelope valuation for Ripple. Here is one possible way to think about this. Assume the global daily foreign exchange volume is USD 5 Trillion. Let’s assume Ripple has 10 percent market share and moves around USD 500 Billion a day using the XRP network for major banks and financial institutions. Now let’s assume, in time, Ripple can capture 0.1 percent of the notional sum above as revenue. That amounts to USD 500 mn of revenue per day. That’s USD 15 bn a month and USD 180 bn 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 USD 360 bn.

At Ripple’s current price of USD 2, its market cap stands at $80 bn. So if we were to use our above framework (and the reader can tweak around with the numbers to arrive at his/her own fair value), we can arrive at a target price of above $8 which implies a 4x return from here. Build your own models and frameworks before buying Ripple. Don’t buy it because it is available for USD 2 per unit. There is a big difference between price and value.

(Vatsal Srivastava is a senior financial commentator based out of New Delhi.)

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