If you’re familiar with traditional financial markets like stocks, you’re probably familiar with what a market cap is. But when it comes to cryptocurrency, many new and especially young people are joining every day, and many of those people may know nothing of how many financial basics like how a market cap works, or what it means. It’s very important to understand how a market cap is calculated because it can be an important guiding factor in investment decision-making.
Sometimes, it can be easy to misjudge the price of a cryptocurrency by thinking it’s cheap or expensive when only considering the coin price. This is a classic mistake among new investors.
In this article, we’re going to go over all the basics of what a market cap is, how it’s calculated, and how it can or should influence your investment decisions.
What is a Market cap?
In the simplest terms, a market cap represents the total estimated value of a company, or a cryptocurrency in our case. A market cap is calculated like this:
(Price per coin) x (total supply available) = market cap
Let’s give a simple example. Imagine that we have a fictional cryptocurrency called Blockonomi Coin. There is a total of 1000 Blockonomi Coins available, and each one is trading for one dollar. This means that our total Market cap is $1000. If the price of each Blockonomi Coin drops to $.90, then our market cap also drops to $900.
What’s important about market cap is that it’s highly dependent not only on the price of each coin or token but on the total supply available.
Let’s look at a real-world cryptocurrency. Dogecoin, which we wrote about previously here, is quite popular and has been around for many years. Its market cap is about $700 million today, making it one of the more valuable cryptocurrencies around. Typically, it is among the top 50 most valuable cryptocurrencies. And yet, the price of each Dogecoin today is just $0.006. The reason why the Market cap of Dogecoin is so high is that despite the fact that each individual coin has a low price, there is currently 116 billion Dogecoin in circulation.
Now let’s compare this to another real-world cryptocurrency. If we look on coinmarketcap.com, we can find a cryptocurrency called Blocknet or BLOCK for short. Each BLOCK is worth just about $38. At first glance, it may seem that Blocknet is worth a lot more than Dogecoin. However, Blocknet only has a market cap of $190 million, making it worth overall less than half that of Dogecoin. This is in part because Blocknet only has a circulating supply of about 5 million units.
Less supply generally equals higher coin prices
The way that market cap works is highly related to the number of coins on the market. If we compare bitcoin to Ethereum, Ethereum has several times more the supply than bitcoin. This means that even if Ethereum had exactly the same market cap as bitcoin, each unit of Ether would still be worth less than each bitcoin. This again is simply because the total market cap is divided up into more individual units, thus making the price of each individual unit lower.
Another way to think of this is by comparing cryptocurrencies to a fiat currency like the dollar. Most cryptocurrencies have a fixed supply, meaning that there can only be a certain amount of them ever. With bitcoin, for example, there can only ever be 21 million individual coins. Now let’s compare this to US dollars. With dollars, there is no fixed supply. There is nothing stopping the central bank from printing more and more dollars.
So why doesn’t the central bank just print unlimited dollars and make everyone in the country rich? This is tied into the market cap. The more dollars the central bank prints, the less each dollar is worth. The same is true for cryptocurrencies. If someone were to make a fork of bitcoin that had exactly double the supply and that managed to keep the exact same market cap, then each unit of this fork would be worth exactly half of what a bitcoin is worth.
As there is nothing stopping a central bank or government from printing more and more fiat currency, more and more investors are getting into cryptocurrency. While the value of fiat currency always drops over time, cryptocurrencies are reverse and tend to increase over time due to their limited supply. This is also what’s known as a deflationary economic model. Cash, on the contrary, is inflationary by design.
Investment decisions and market cap
When someone is looking for a new cryptocurrency to invest in, they need to consider the market cap just as much as they consider the token or coin price. While it’s very tempting to buy up thousands of coins that are worth next to nothing, that may not necessarily be a wise investment decision.
Let’s look at Dogecoin for example. Dogecoin has performed relatively well over the last few years. However, Dogecoin has always had a very low price per coin. A bad investment strategy would be to buy up a large amount of Dogecoin with the expectation that the price would double, triple, or even hit a price like one dollar in the short term.
You may be thinking to yourself, many cryptocurrencies in the top 50 are worth well over a dollar. So if you invest a large sum into Dogecoin and it goes to a dollar, you will make a fortune. But we need to consider the market cap first. What would the market cap of Dogecoin need to be if each one was worth one dollar? The answer, quite simply, would be $116 billion. That would make it the number two cryptocurrency by market cap today, being worth more than Ethereum and catching up quickly to bitcoin. While not absolutely impossible, the odds of such movement happening within a short timescale is practically impossible. Dogecoin can be a good investment for some portfolios, but when investing in a currency like it, you need to have a realistic plan based on a solid understanding of how market cap works.
The “market cap represents the amount of fiat money invested in the currency” myth
Some sites and guides on the internet will tell you that a coin’s market cap is roughly representative of the total amount of fiat currency (or equivalent value in other cryptocurrencies) that has been invested into the coin. This is not true, and it’s important that investors understand why it’s not true.
Let’s start with an example. Imagine, for instance, that the previously mentioned fictional Blockonomi coin has just been created and is now on the market for the first time. Remember that we have a total supply of 1000 Blockonomi coins in the market. Now let’s imagine that someone agrees to purchase a single Blockonomi coin for $5. This is the only purchase of Blockonomi coins that has ever occurred. However, our total market cap is now instantly $5000. This is because the current asking price on the exchange where Blockonomi coins are being traded is $5. $5 times 1000 units equal $5000. Now let’s say that the next trade that goes through is $4.50 for a Blockonomi coin. Now, the market cap has dropped by $500.
In the above example, only $9.50 was put into Blockonomi coin. And yet, the market cap is already $4500-$5000. Therefore, the market cap does not represent the amount of money invested in a coin or token, it is simply a calculation based on the current going price times number of shares available.
Summing it all up
So what does all this mean for you? As a clever investor, understanding how market cap works, and how it’s calculated is an important tool for your toolset. It is important to not only look at the price of each individual coin or token but to understand where that price comes from, and where the cryptocurrency in question sits in comparison to other cryptocurrencies by market cap. It’s also important to keep expectations realistic when dealing with cryptocurrency’s that have huge supplies and low coin prices. These can be good investment vehicles, but one needs to fully understand where the low price comes from, and if it’s a good investment for you personally or not.