Making Sense of Crypto Asset Valuation Insanity

Cryptocurrency investors are blind to the most important factor of any investment – valuation.

Merely uttering the word “blockchain” has been a hypnotic weapon, sending investors into a trance where they clamor to buy at any price.

Tea cup from Get Out: The process of sending blockchain investors into hypnosis.

Raiblocks investors in “the sunken place.”

This isn’t the first time growth investors have gone wild. Technological innovation typically turns investors into emotional basket cases. Today, a blockchain protocol with any facade of technical aptitude is valued at eight figures.

Throw out a $10-term like “DAG” or ‘interoperability” and you’ll get nine figures.

And these low eight- or nine-figure valuations are turning into 10-figure valuations. Wash, rinse, repeat…. The blockchain voodoo is working.

Blockchain investors using jobu to increase protocol valuation.

Well, for people who view tokens as a casino chip instead of an asset who’s value will ultimately converge to fundamental value….

Spoiler alert: this won’t end well.

Crypto assets are “different”…

Hiding behind the pseudo-science of white papers and platitudes like “decentralized technology bringing a new era,” many investors believe crypto assets are “different.” If transactions increase, the protocol will go up in value…

History tells us it can’t be that simple.

The “Nifty Fifty” of the 1960s, a group of 50 stocks that represented some of the fastest-growing companies on the planet, bought regardless of price, epitomizes a case of growth investing gone wild. The goal of the approach was to identify companies with the most optimistic outlooks in earnings growth. The stocks that highlighted “America’s great stocks” lists were Xerox, Kodak, Motorola and Texas-Instruments.

These stocks were meant to be bought and held, not sold. As a result, investors disregarded valuation. The prevailing mentality was that “even if the asset is expensive today it will grow into its price.”

“Hold!” they said. The resulting P/E ratios in 1972 are shown below.

What do you notice about the names above?

The spectacular growth abruptly came to an end for many from technological obsolescence and competition. P/E ratios for the 50 stocks selected collapsed to 10. By 1975, the Nifty Fifty had shed two-thirds of its value.

Newly conceived ICOs are raising at valuations in the hundreds of millions and the same venture investors that would scoff at a $500 million valuation in the “real world” are lining up to buy tokens with no recourse and without any regards for valuation.

Valuation is the least important factor instead of the most. And as a result, there are 24 early-stage crypto assets with a valuation over $1 billion, most of which only have one value proposition: speculation.

If you were planning to buy a new house, hopefully you’d ask what the price is. But instead, just like with housing leading up to 2008, blockchain investors have been lured into believing that growth alone obviates any need for valuation rigor.

When price starts to diverge from value, and growth at any price becomes the general market sentiment, risk adjusted returns fall dramatically. Crypto investors will ultimately need to have a strategy, other than selling the token to a greater fool.

The long-term crypto investor

The most important factor driving an investment success or failure is the relationship between the price you pay and the asset’s worth. A fundamentally strong asset can be a bad investment if too optimistic of expectations are priced in and vice versa.

What tends to get investors into trouble is conflating “interesting asset” with “interesting at any price”. I’m fascinated by the vision for a “world computer”. But that alone doesn’t mean Ethereum is a high expected value bet at a $100 billion valuation.

Objective merit alone is about as good of a predictor of price increases as Jamie Dimon’s forecasts are.

There are two fundamental investing approaches that warrant dissection: value and growth. Value investors look to buy the proverbial one-dollar bill for $0.80. Growth investors look to buy a one-dollar bill that can turn into a fancy new bio-tech drug or consumer application worth $5 10 years down the road. Either strategy can work.

But regardless, both schools of investors still need to accurately price and understand what constitutes “low” and “high” for any given asset. If the asset purportedly worth $1 turns out to be worth $0.25, both investors are overpaying and reducing risk adjusted returns substantially.

Generally, the early stage investment realm is dominated by growth investors due to the difficulty of determining present fundamentals.

Due to the future uncertainty, growth investors like venture capitalists typically require a higher rate of return to compensate them for the risk. According to CB Insights, only 0.91 percent of startups make it from seed stage to greater than $1 billion in value.

Thus, seed valuations need to be more than $10 million ($1 billion multiplied by 1 percent) and returns need to be higher than 100x for the bet to be expected value positive at that failure rate (100x multiplied by .$01 = 1x money). (This is a slight oversimplification but helpful for purposes of this analysis).

The bottom line is that the initial valuation matters and needs to compensate you for the risk.

Many crypto assets are undoubtedly riskier – you’re trading the preferential rights and recourse of an equity investment for a tote bag and a token with an unproven value capture mechanism.

In fact, according to Fortune, 60 percent of ICOs have already failed after just two years – talk about not wasting any time. Required return, or the discount rate, needs to be higher for crypto assets to generate a positive expected value. Given the increased risk, you’d think crypto valuations would be lower than early stage venture capital but instead they are order(s) of magnitude higher.

Because valuations are already in the hundreds of millions, investors need conviction that these protocols will ultimately be worth tens of billions to generate a substantial risk adjusted return (10x-50x required return multiplied by hundreds of millions = $billions).

For those already worth billions the challenge is clearly magnified. Billions of dollars of value capture is not in and of itself a problem. But in crypto it will be for many assets because the only way that a crypto asset can be worth tens of billions of dollars is if it becomes a reserve store of value.

This is a non trivial task, to say the least. Let me explain…

Reserve stores of value

The key to ascertaining fundamental value in crypto is an understanding of [1] economic activity – transactional usage of the token + the store of value component and [2] velocity – how frequently the token changes hands.

The matrix below helps me think about value accrual along these two dimensions using the quantity theory of money – the best framework to reason about currency and token valuation today:

This matrix paints the picture that the only way an asset can ultimately be worth more than $1 billion is if it is in the bottom right quadrant: High economic activity and low velocity. ($10 billion divided by 10 = $1 billion market cap)

Every other quadrant is relegated to the world of nine figures, largely because of the importance of velocity.

Recognizing the importance of velocity, there’s been a lot of work done to manipulate it through relatively complex mechanisms. However, I tend to agree with Nic Carter below on most “solutions” I’ve seen.

If users are reluctant to hold the token, in more cases than not, there’s no escaping the high velocity that will ensue…

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