New Asset Valuation Techniques May Be Reason to Give Pause

I’ve been fascinated by this downturn in crypto, not from an investment standpoint, since even though I took some profits off the table at the top, I’m still heavily invested, but because it has been an extremely interesting application of behavioral finance in real life.

In my opinion, when it comes down to it, cryptos are an alternative asset class. They hold some value. But nobody knows how to value them, so what happens is that FUD and greed end up playing a much larger role in their pricing than they do in traditional assets.

As we’ve seen over the past few years, it doesn’t take much for the price of a crypto to turn on a dime. The market for these things is extremely fickle, and I think a lot of that is due to the fact that nobody really knows what to make of them yet. I’ve said this before too — cryptos have a lot of potential, and they do seem to have some economic value by way of their use to power an underlying technology that requires real world resources (time, electricity) that results in a cost to those that validate transactions. But how we actually value them is still a big question.

When the market was overheated late last year, I started to read about a lot of valuation methodologies for cryptos. Some of them, like the one that Chris Burniske proposes in his book, kind of make some sense, because they tie the underlying value of an asset to the real world value that those assets provide in terms of actual economics. But what worried me was that I started to see a whole lot of valuation metrics that had nothing to do with real world economics. Things like trying to tie the value of a crypto to how many times people used that crypto to transact made no sense to me. If I recall correctly, there were a couple of other methodologies that tried to value crypto without actually taking into account the actual value of what that crypto was doing in terms of real life monetary economics.

In retrospect, whenever this happens, it tends to be a major red flag for the value of an asset. The same thing happened in the dot com era. People stopped valuing companies on the amount of money they could generate and relied more on “eyeballs.”

These alternative valuation methodologies are problematic because they attempt to provide the value of an asset in monetary terms, for example, the USD, without actually taking into account the monetary value that’s provided by these assets. When that happens, there’s a disconnect between where the asset is truly valued and the value that people ascribe to these assets using their newly developed methodology. And when there’s a disconnect, the market doesn’t take long to correct.

This is why I think that traditional valuation methodologies, flawed as they are, should still be used for most assets that have some underlying monetary value. Obviously these methodologies don’t work for everything (i.e. gold, artwork), so this isn’t always applicable. But creating new methodologies that are unlinked to the underlying economics of an asset can be more dangerous that attempting to value an asset based on more traditional methods.

In the long-term, I still think that there’s value in blockchains, and by extension, in the tokens that power those blockchains. But I also know that it’s almost impossible to know for sure at this point, so any dollars (or yuan, or Euro, etc) put into the underlying tokens is more of a gamble than an investment, but it is one with an asymmetric risk, and those are the types of investments that generate true, meaningful wealth for people, so I’m not calling it quite yet.

Let’s see what the future brings.