[SYGNUM] Valuing crypto assets

The invention of cryptocurrencies created a new type of asset. But how these assets create economic value and how to estimate this value is still poorly understood in the market. Crypto assets represent investments in early-stage transformational technology where the opportunity lies in medium- to long-term growth.

Any valuation methodology ultimately hinges on forecasting this growth. Assessing the fair value of tokens also involves modelling how projects capture value and how this value is transferred to tokenholders, but the starting point in all cases is understanding the size of the opportunity.

• Intrinsic value: Any currency or asset derives its value from one of two things: it generates value (e.g. stocks and bonds through the activity of the issuer) or there is reliable demand for it (e.g. commodities). Unlike fiat currencies, cryptocurrencies have an intrinsic economic value, derived from the activity of users and projects built on top of the blockchain. Users of the protocol pay transaction fees and this transaction-fee economy provides a baseline for the value of the token.
• Security value: The extent to which a currency or asset can be securely stored affects its value. In the case of fiat currencies, deposit insurance schemes provide this security – up to a certain amount.
• Value of governance rights: Whether the tokenholders’ governance rights have any value depends on whether they can make decisions that influence the economic value of the tokens. For example, the governance rights of a decentralised finance protocol are valuable where decisions can be made about the distribution of platform revenues between liquidity providers, the project’s treasury and tokenholders. But ‘governance rights’ that merely allow tokenholders to decide on matters that have no economic relevance have very little value beyond some indirect impact by encouraging engagement.
• Utility value: Whether a token derives any value from its purported utility depends on the economic impact of the activity. Native tokens of blockchain protocols such as Ethereum provide genuine utility by securing the network. Tokens that carry rights to discounts or other economic benefits have a value equal to the value of those rights.
• Memetic value: Sometimes a community converges around a ’meme’, occasionally inspired by endorsement by a celebrity. But such a community only has economic value if there is an intention, and actions taken, to convert it into some productive activity.

Commonly used valuation techniques

• Stock-to-flow: A valuation technique borrowed from the commodities market, it assesses the relative scarcity of an asset by comparing its existing stock (supply) to newly created supply (flow). But unlike commodities whose demand is largely predictable, ignoring the demand side when valuing Bitcoin is not a reasonable valuation methodology. Indeed, valuing cryptocurrencies involves assessing the fair market capitalisation, and the token supply is used merely to translate this into a fair price per token. The supply in itself does not drive the fair market capitalisation.
• NVT: The network value to transactions ratio compares the market value of a cryptocurrency to the volume of transactions processed by the network. The metric can highlight valuation anomalies across tokens or for the same token over time.
• Fees, revenues or profits vs market capitalisation: Instead of using the transaction volume, similar ratios can be calculated by using the fees paid to the protocol, the revenues or the profits earned and comparing them to the token’s market capitalisation. These metrics have a higher information content because a high volume of transactions at very low fees may generate less economic value than lower volume at higher fees, and, ultimately, the token’s fundamental value is driven by the value it captures.
• Network effect – Metcalfe’s Law: ‘Metcalfe’s Law’ says that a network’s value is proportional to the square of the number of nodes in the network. It is an important insight for valuing blockchain protocols, as it highlights that the value of a network grows considerably faster than its user base.
• Miners’ cost: Some have proposed that the cost of producing a cryptocurrency puts a floor under its valuation. This is no more true for cryptocurrencies than for any other product. If the market does not pay a price that is higher than the production cost, the latter needs to adjust or the company in question will go out of business. We saw this recently when Bitcoin miners’ costs exceeded their revenues. This did not lift the price of Bitcoin, nor did it give Bitcoin any ’value’, rather miners started going out of business.
• Comparables: Although not a technique to assess the absolute value of a token, comparables provide useful pointers for the relative value of cryptocurrencies. Various metrics such as the number of active users, connected wallets, unique visitors and so on can be tracked and compared across protocols and over time.
• Measuring protocol quality: Although not valuation methodologies as such, metrics that measure a protocol’s quality across various metrics nonetheless provide useful insights that can be used to assess whether a platform has better or worse growth prospects.

Valuing crypto assets is complex, as the market is made up of different asset types, and the cryptocurrencies at the core of the market derive their value from multiple sources. This is further complicated by the early-stage nature of the market where valuation requires making forecasts about growth that is still far in the future but is likely to be exponential.