What is Market Cap and Why is it a Vanity Metric?

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By Max
Estimated reading: 6mins

A market cap is a large number that shows how many tokens are in circulation and their total market price. While it shows how many coins are tradeable, it doesn’t show the real market demand. For example, it doesn’t include the number of tokens locked in DeFi protocols unlike the Total Value Locked (TVL).

How is Market Cap Calculated For Cryptocurrencies?

The most successful cryptocurrencies often have the largest market caps. Today, overall crypto markets have at least a $1 trillion market cap, 60% of which comes from Bitcoin and Ethereum. Out of the thousands of tokens, only a handful make up 90%+ of the market valuation.

People also like investing in large-cap tokens because they’re often associated with high volume, demand, and utility. Whether that’s true or not, the general assumption is that high market caps indicate incoming price increases.

While correlated, this isn’t really true:

Market capitalization is calculated by multiplying two metrics: the latest token price and circulating supply. You can see that trading volume doesn’t appear in the formula, which is why market caps aren’t useful trading indicators. But they’re useful to understand your project’s tokenomics:

  • If the circulating supply stays the same, the market cap chart equals the price chart. That’s the case with many cryptocurrencies.
  • If token prices stay the same, the market cap shows the live circulating supply. That’s the case with stablecoins.

While market caps don’t show actual demand, they do show the supply that regulates that demand. For example, a stablecoin reducing its circulating supply might indicate reduced liquidity and potential de-pegging. A cryptocurrency that approaches its max supply might lead to price rallies because of scarcity.

When you multiply the price by maximum supply, it’s called Fully Diluted Market Cap. It hypothetically shows much the market could be worth at current prices. If there’s no max supply, it’s the same as the ordinary market cap.

The Problem with Market Cap

Market caps can be insightful for the few coins that dominate the crypto markets. But for the most part, the market cap is a vanity metric. Big caps have higher credibility and attract more buyers, but they don’t mean much to value investors and technical analysts.

Here’s why:

  • Price doesn’t equal demand. High prices don’t always mean that traders are buying more. Many coins under $1 have the highest market caps in the market. As another example, Polkadot’s governance decided to reduce prices by 100X while airdropping 100X tokens to existing holders in 2020 (see Denomination Day).
  • Token supply is complicated. Circulating supply doesn’t equal liquidity because tokens can be locked on staking protocols, held in cold storage, or lost. The token might have a sky-high max supply, no supply limit, or a flexible cap. Also, the governance community might be able to change both circulating and max supply.
  • You can’t make money on market cap, only price. Market cap might show there’s enough liquidity to sell, along with the hypothetical tradeable amount. Market caps can go up without upping prices. In fact, they’re more likely to go down because of increased supply.
  • Market cap doesn’t equal product market fit. The price depends on Bitcoin’s dominance, circulating supply, and demand. Circulating supply depends on tokenomics and governance decisions. None have anything to do with product market fit, which is what causes demand to increase consistently long-term.
  • Market caps change as quickly as prices. In the volatile crypto markets, market caps can change by 20%+ overnight just like prices do. When trading micro cap tokens, it’s even more unreliable. Market caps and prices often move together in the charts, so there’s no way to anticipate one with another.

The overall cryptocurrency market cap is just as meaningless:

  • Different market caps are incompatible. Different coins are different products, yet crypto explorers arrange their lists by market cap as if they were the same. Founders can start with any token supply they want, making prices incompatible. E.g., Does $50 make Solana worse than a $300 BNB?
  • Market caps aren’t proportional. When caps go from $1T to $2T, it doesn’t necessarily double your coin’s market cap and price. Most of it will go to Bitcoin, Ethereum, stablecoins, and major altcoins if there’s demand. Also during bull runs, even small-cap tokens reach market caps between $100M to $500M.

If you completely removed market caps from metric analysis, you’d still be able to trade just as effectively.

How to Actually Value a Cryptocurrency

Calculating cryptocurrency value is a lot more than looking at market caps or prices. It’s about understanding the utility of a project and how it reflects on the price in different markets. There’s no easy way to find homerun projects overnight, but there are fundamental principles for crypto investing that you can follow:

  • Assets with product-market fit. A project is valuable when there’s a market need for the solution offered (technology). Unlike market demand, need means that the problem is common and relevant, and people are willing to pay to solve it because there aren’t competitive solutions. Projects with product-market fit stay ahead of competitors and become irreplaceable for users, which is soon reflected in the price.
  • Cryptocurrencies with proven decentralization. Decentralization is the major selling compared to fiat money because it empowers users. Decentralized cryptocurrencies have no admin keys, no governance, and allow you to trade with your exclusive, non-custodial crypto wallet. If there aren’t enough nodes, or developers have admin access, that defeats the purpose (and price potential) of the currency.
  • Engaged communities. A clear sign of product-market fit is finding people using the project. If many people follow a project, it shows there’s an active team behind it, good token utility, and exciting updates coming. Communities are self-reinforcing because they attract more users the bigger they get. Some users eventually become die-hard holders.
  • Analyze the tokenomics. The ideal tokenomics include limited maximum supply, high circulating supply, and dispersed token allocation. For example, allocating too much to developers sometimes leads to rug pulls/exit scams. If it’s a DeFi protocol, then tokenomics should lead to a balance between TVL (earning while holding) and circulating supply (trading).

Explore the ecosystem. Just like transactions become safer with longer chains of blocks, projects solidify their market value when others build on top. One reason Ethereum stands so well against superior blockchains is that it has the largest ecosystem of apps, forks, and layer-2 solutions. If the project is also cross-chain compatible, it becomes more accessible outside its ecosystem.

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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.

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Max is a European based crypto specialist, marketer, and all-around writer. He brings an original and practical approach for timeless blockchain knowledge such as: in-depth guides on crypto 101, blockchain analysis, dApp reviews, and DeFi risk management. Max also wrote for news outlets, saas entrepreneurs, crypto exchanges, fintech B2B agencies, Metaverse game studios, trading coaches, and Web3 leaders like Enjin.

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