How to Value Digital Assets
“Crypto Assets Have No Intrinsic Value”
This is the typical narrative according to people who are sceptical of digital assets as an investment proposition. It’s been more than 6 years since I started researching and investing in the digital assets market, which actually makes me a veritable old-timer in the space! Unlike most crypto veterans, however, I don’t believe in short-term day trading, nor do I use technical analysis much. Instead, I am a firm believer that — just like when investing in small-cap equities — a crypto project’s superior fundamentals are the most important factor in determining its long-term value. I honestly love researching and identifying crypto protocols with attractive fundamentals but I must admit that seeing the Eureka moment on people’s faces when they realise the truly transformative nature of blockchain technology is also pretty exciting.
If you don’t know anyone personally to educate you on the merits of Crypto, I have bad news for you: leading business news sources don’t seem to be interested or particularly well-informed. To this day, I’m baffled by the lack of media coverage of the raft of positive fundamental developments in the digital assets sector that we see every day — even in this savage bear market!
Put in simple terms, the blockchain is a technology that offers a faster, cheaper, and more secure way of transferring value than we have today. Not surprisingly, therefore, it is experiencing exponential growth in end users and rapid big business adoption, not to mention experimentation from central banks. In investment potential terms, it’s as attractive as it gets.
So why aren’t digital assets being taken seriously as an investment proposition? I personally think it’s because many people can’t see that digital assets are no different — in investment terms — from traditional stocks, in the sense that they are in fact just like any young business looking to develop a large and growing revenue stream. As such, we as investors can try to forecast and measure these sales as a bedrock to the intrinsic value of the project. Crypto has now even been around long enough that we are seeing the most successful projects building sustainable business models and, just like in equities, any success they have in developing the business accrues to their owners (in crypto’s case, their ‘tokenholders’). Today I would like to explain how we can apply a pretty conventional fundamental analysis approach to looking at digital asset projects.
The Digital Assets Sector: Where are we Now?
The digital assets market has come a long way since the creation of Bitcoin in 2009. Bitcoin was a unique and groundbreaking innovation that made it possible to transfer assets digitally without needing an intermediary to process the transaction. Ethereum came next and improved the technology by allowing for the creation of smart contracts which effectively added ‘conditions’ to this peer-to-peer transfer. This essentially means that the terms of economic interactions (i.e. the contractual obligations of users and ‘service providers’) would be set by code at the outset and could not be altered after the fact. The creation of smart contracts led developers to experiment with blockchain-based iterations of financial products and services such as spot trading, lending and borrowing, derivatives, and futures, replacing the middleman with code in the process. Following these exciting innovations enabled by Ethereum, a raft of newer crypto protocols have added other useful steps forward, and the industry has therefore continued to grow, mature, and even thrive despite a number of financial crises. Many traditional finance professionals understand the attractions of blockchain technology but cannot see how the value accrues to digital assets. Today, I would like to explain just that: how this value accrues to tokens.
Owning Tokens is just like owning a stake in a Company!
In the same way that a company offers shares, blockchain protocols issue digital tokens. Like shares, tokens represent a stake in the success of that particular project. They are used to finance the growth of the project, i.e. the costs of team compensation, business expansion, and user acquisition. In exchange, investors in a particular token benefit from the overall growth and success of the project in the form of an appreciating token price. Contrary to the popular myth that token prices are irrational, their long-term value is actually deeply rooted in the growth of their blockchain project. Tokens, equivalent to shares in traditional companies, increase in value principally as a result of increased revenues. Higher revenues are usually based upon some competitive edge for the project, for example, the superiority of the technology, the calibre of the team, and/or the business strategy. In blockchain projects, you often hear talk of ‘adoption’: this basically means rising market share and refers to the increase in the number of active users, developers, and — in the case of blockchain infrastructure — the number of ecosystem applications built. It’s as simple as that! If you think about it, there are the exact same drivers behind a small and fast-growing company as there are behind a fast-growing digital asset project! In both cases, we are looking for evidence of customer traction relative to the competition, and we are also analysing how sustainable the project’s key competitive advantages driving this traction actually are.
Source: Token Terminal
But like all things in life, it’s not quite as simple as that! It may surprise you to know that we as digital asset investors actually believe that it’s not ALL about the technology. While the robustness of the technology and its ease of use are compelling factors, in a fast-moving cutting-edge technology sector, we do not believe a technological lead necessarily represents a source of long-term competitive advantage. For sure, a tech lead can get a newcomer into the race, to begin with. But don’t forget, the code is predominantly open-source and free to use and the sheer numbers of talented developers and investment capital attracted to the space mean there are always innovations happening. This means that a sustainable competitive edge is more likely to be based, for example, upon the calibre of the management team — one that relentlessly executes against a strategic vision that’s aligned with evolving market needs — than it is upon a superior technology.
Our humbling investment mantra is “the customer is always right”! This means we actively favour those projects that we see customers choosing. If customers are choosing your solution, it is the acid test that you have the most attractive product offering in the current market. The most exciting element of this customer-centric approach is we often find relatively new, under-the-radar projects in this space which are actually attracting large enterprises such as Starbucks, Google, and Mercedes. We believe partnerships with such mammoth organisations not only turbocharge the demand for a blockchain protocol and build its brand but also provide a stickier market lead and therefore better future prospects.
Token Value is Ultimately Driven by Fundamentals
It is my strong belief that we can measure the real intrinsic value of tokens and that this value is, over the longer term, primarily driven by the same fundamental business factors that also drive the value creation in smallcap company shares. Token prices invariably increase when a project gains traction in the form of higher revenues. What sets a project apart is how sustainable its competitive edge actually is. Accordingly, to benefit from an investment that is more likely to offer high returns for a longer period, we as investors not only look at the pace of growth but also favour those projects that look set to maintain their edge thanks to powerful partnerships and an enviable competitive positioning.
RMP is a Co-founder of Dragonfly Asset Management.
DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.
