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Beyond Speculative Trading: The Investor’s Guide to Crypto Asset Valuation

Carlos Gonzalez Campo

Carlos Gonzalez Campo

Carlos Gonzalez Campo is a Research Analyst at 21Shares.

Crypto asset valuation remains an emerging topic seeking consensus, especially as the asset class expands and matures. Robert Greer, author of "What is an asset class anyway?" argues that assets that lack an objective measure of value and have a supply constraint are more vulnerable to irrational exuberance, citing the dot-com bubble as an example. Crypto assets lack an objective measure of value today among investors, similar to emerging tech companies in the late 1990s. We propose valuation methodologies that reconcile different approaches investors have taken in recent years.

Intrinsic vs. relative asset valuation

We can value any asset using two approaches – intrinsic or relative. Intrinsic valuation measures an asset's value based on its capacity to generate cash flows. On the other hand, relative valuation methods, also called "pricing," estimate how much to pay for an asset based on what others are paying for comparable ones.

Digital Monitor with market analyses graph

Investors might use a discounted cash flow method (DCF) to value a stock, but they wouldn't use that for a piece of fine art. Similarly, we must outline the various types of crypto assets to understand the differences we may expect in their value accrual and specific valuation approaches. In this regard, it's helpful to categorize crypto assets according to the three asset superclasses proposed by Robert Greer:

  1. Capital Assets: “An ongoing source of something of value” (e.g., bonds and stocks).
  2. Consumable/Transformable Assets: “You can consume it. You can transform it into another asset. It has economic value. But it does not yield an ongoing stream of value” (e.g., physical commodities).
  3. Store of Value Assets: “They cannot be consumed, nor can they generate income. Yet they do have value” (e.g., currencies and collectibles).

Like the Internet architecture, crypto assets and blockchain technology have two layers: (1) infrastructure and (2) applications. In his 2019 work, Chris Burniske categorized crypto assets at the infrastructure layer based on the consensus mechanism of the blockchain:

  1. Proof-of-Work (PoW): In PoW networks like Bitcoin, the native asset (BTC) relies on a computationally and energy-intensive lottery called mining to determine which block of transactions to settle on the blockchain and reward the miners. Hence, they belong to the Consumable/Transformable asset superclass, as they essentially create “a digital-native commodity in the form of secure, globally accessible ledger space.” Investors can use the mining cost of production as a fundamental metric to gauge the lower-bound value of PoW crypto assets like BTC.
  2. Proof-of-Stake (PoS): In networks like Ethereum, validators must commit a portion of their capital – the “stake,” in this case, ETH – to gain access to a recurring value stream generated by the network’s rules. Hence, they fall in the Capital Asset category, and their value may be derived from the net present value of annual flows to validators using a DCF method.

While we won’t delve too deeply into the application layer, we can apply the same first-principles thinking:

  1. Governance tokens yield voting rights and represent ownership of the application. They are analogous to common stock in traditional finance, so they fall in the Capital Asset class.
  2. Utility tokens drive the economics of the system as their sole function, meaning they fall in the Consumable Asset category.
  3. Non-fungible tokens (NFTs) are collectibles like fine art in their most typical form today, falling in the Store of Value category.

Intrinsic valuation: Ethereum

From the standpoint of a validator, PoS assets like ETH are akin to a stock paying a dividend yield, which means we can conduct a DCF valuation following four simple steps:

  1. Estimate the cash flows during the life of the crypto asset

    a. Transaction fees within the network accrue to validators. Just so, fees are a proxy for revenue. Ethereum validators received $274.96 million in transaction fees (net after the burn mechanism) from Sep 15, 2022 – when the network transitioned to PoS – to June 30, 2023. In our model, this translates to annualized fees of $348.48 million.

    b. Token issuance doesn’t dilute the value of validators. On the contrary, they have the right to new issuance, similar to how shareholders may receive stock-based compensation. ETH Issuance from Sep 15, 2022, to June 30, 2023, amounted to $852.17 million, translating to an annualized issuance of $1.08 billion.

    c. Total Cash Flows: a + b = $1.43 billion in the first year.
  2. Estimate expected future cash flows and the lifespan of the crypto asset

    a. Future cash flows: We propose a slight variation of the three-stage growth model to project Ethereum’s future cash flows. Specifically, we forecast an initial period of aggressive growth, followed by an incremental decrease that eventually stabilizes at a more moderate growth rate.

    b. Lifespan of the asset: With public companies that at least in theory can last forever, equity analysts generally assume that cash flows beyond a specific point in time continue in perpetuity. Investors may apply the same logic to PoS crypto assets, but for simplicity’s sake, we assume ETH’s life will be 20 years.
  3. Estimate the discount rate to apply to these cash flows

    a. Lower-bound discount rate (13%): In the last 30 years, the Invesco QQQ Trust ETF obtained a 13.03% compound annual return.

    b. Higher-bound discount rate (19.19%): Obtained using the Fama and French Three-Factor Model (market premium, size premium, and value premium).
  4. Estimate the net present value (NPV) of cash flows using the above parameters

Assuming a discount rate of 13%, the implied price per one ETH today would be $2,725, a 60% increase from ETH’s current price (~$1,700). On the other hand, if we use a 19.19% discount rate, the implied price per ETH would be $1,349. Investors should interpret the results of this DCF valuation with caution and run their own assumptions. The rationale behind our approach was to be conservative and capture the high volatility of ETH in the discount rate to accurately reflect the asset’s riskiness. Another implicit assumption in our analysis is that the asset’s monetary premium (“Store of Value” component) is embedded into the DCF.

Intrinsic valuation: Ethereum

Source: 21Shares

Relative valuation: Bitcoin

A significant portion of equity valuations in traditional finance consists of relative valuations based upon market sizing and multiples, such as price-to-earnings (P/E ratio). This approach is more likely to reflect market perceptions and sentiment than a fundamental valuation. Moreover, investors can use relative valuations to "price" any asset, not just ones that generate cash flows. Although one can choose from an extensive set of multiples and comparables, for illustrative purposes, we'll concentrate on just one of the most actionable indicators for BTC.

The market-value-to-realized-value (MVRV) is a simple yet powerful on-chain multiple that leverages the transparency of the blockchain:

  • "Market value" refers to the current value of supply (market cap);
  • "Realized value" refers to the cost basis of supply.

High MVRV values indicate a substantial degree of unrealized profits in the system. In contrast, values below "1" indicate that a significant portion of BTC's supply is near break even or at a loss. Historically, high MRVR ratios have coincided with BTC market tops, while values below "1" have preceded past cycles' bottoms.

Challenges to crypto asset valuations

There are various challenges and shortcomings regarding crypto asset valuations, such as insufficient historical data and complexities unique to the asset class.

For instance, the cash flows that PoS networks generate are not paid in fiat currency but rather in the native tokens of the network. This situation is as if Apple charged its customers in Apple shares instead of U.S. dollars. This unique feature creates a reflexivity problem because the dollar-denominated value of the revenue stream is directly dependent on the crypto asset's value.

We have provided investors with actionable methods to value crypto assets. The complexity and uncertainty of valuing this asset class might intimidate investors. However, it is worth remembering that the more uncomfortable an investor feels when valuing an asset, the greater the payoff of doing the valuation.

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