Quick Guide to Smart Cryptoasset Valuation
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Fintech industry has been on fire lately, as new, industry disrupting projects have surged in the recent years, threatening even the most prominent and well-established players. While all of this seems to benefit consumers, it also presents a new set of challenges for investors. Peer to peer loans, ICOs or cryptocurrency trades are just a few new ways to put your money to work. Some of the innovative companies, are even reaching for the middle ground between the P2P loans and cryptocurrencies, as they gain traction and promise significant returns. Nevertheless, estimating the value of a consumer loan is much more straightforward process than cryptoasset valuation. Most of the cryptocurrency investors did not even have a solid framework to do so until lately, but as with every rapidly developing industry, new valuation ideas emerge along with the growing numbers of various stakeholders. This article briefly reviews what does it mean to invest in cryptoassets, how do they capture value and how can you estimate it.
What is an ICO?
ICO stands for Initial Coin Offering. It is a form of bootstrapping and crowdfunding for crypto projects. Put in simple terms, it works like this: the project team launches a funding campaign to develop and fund a new project. In return, all of the backers receive the set amounts of initial project coins. Like stocks, the price of these tokens fluctuates and can experience rapid growth, stagnation periods or dramatic value reductions.
Most ICO’s are based on application-specific crypto coins. In 2017, the amount of money raised through ICOs has already reached over $2.3 billion, which is incredible considering that ICOs became a thing just in 2013. During the period of past few years, ICOs became a prominent tool of financing new crypto projects. They help startups to collect astounding amounts of money that would be impossible to raise via traditional angel investing or venture capital. One of the main reasons for ICOs popularity is its lack of restraints and regulations, which increases their accessibility.
What do investors get out of it?
The surge of ICOs leaves many questions. Why do so many investors decide to exchange their money into digital currencies with a dubious economic value? In fact, what value can crypto tokens capture?
To understand the industry better, let’s classify cryptoassets into four categories.
1) Cryptocurrencies built out of a different codebase with a specialized objective.
2) Cryptocurrencies that changed several technical aspects of bitcoin.
3) Tokens are not meant to be currencies, but rather digital currencies of particular applications.
4) Currencies that are built on top of bitcoin. They use bitcoin as a base protocol, yet extend the use of it.
Despite their differences, all four crypto assets categories represent economic value relative to particular utilities in different applications. Although they all differ by design, their primary objective is to capture economic value and provide mutual benefit to the consumers and the networks.
Like most of the stocks get their value from rights, ability to distribute earnings and price appreciation, most of the crypto coins can obtain their economic value from the service, good or utility of its network and application.
How do cryptocurrencies gain economic value?
According to Alex Treece, valuable cryptoassets share these common characteristics:
1). They are issued on a network with meaningful implications. The idea works and many people actually use it.
2). They are able to capture created value and transfer it to the holder. The established value must exceed the investment costs.
Source: Coinmarketcap
If we looked back at 2013, first four years into the cryptoasset craze, three coins have led the market at the time — bitcoin, ripple and litecoin. Fast forward four years and they still hold a strong market position and have increased their valued many times. The rest of the players still exist, however, their lack of adoption or means to capture value have made them less attractive to the investors.
Source: Coinmarketcap
The basic implication here is that even if crypto assets drive a solid network, the tokens may offer a poor economic value and be bad investments in the long run.
Cryptoasset valuation theories
At this point, most of the tokens are just held by the Investors, who do not intend to use them in the network but rather keep them and wait for the future value appreciation. The lack of functioning products also plays a role, placing the network value on return-expectations. So, the natural question is: what are the actual ways to calculate these returns?
Investor assumptions about token market adoption can have significant differences. However, recently, new feasible cryptoasset valuation frameworks started to emerge.
Chris Buriniske, the co-author of the book Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond, suggests that cryptoassets go far beyond currencies and serve as means of exchange, value storage and unit of account.
According to Chris, a cryptoasset valuation can be solved by finding M in M = PQ/V. In this case, the fundamental equation of exchange is MV = PQ, and when applied to crypto, the interpretation is:
M = size of the asset base.
V = velocity of the asset.
P = price of the digital resource.
Q = quantity of the digital resource.
The more extensive guide with calculations can be found here.
Gregory DiPrisco has suggested the following equation to calculate the utility value of ethereum.
Uv = (Va + Vi) / T
Uv = Utility value of ether.
Va = Dollar value abstracted onto the blockchain.
Vi = Dollar value of the information on the blockchain (gas fees).
T = Number of tokens in the network.
Although this approach is not perfect yet, DiPrisco suggests that the network value to the adopters is not the same as the value of the users to the network. In other words, market capitalization does not reflect the entire financial worth of the system. For a more detailed analysis, check out his thoughts on the subject.
Primoz Kordez has looked into value drivers for blockchain systems. He states that when evaluating the market value of a particular cryptoasset, investors are actually assessing the value of the protocol on which the cryptocurrency is running. Three types of cryptoassets can be distinguished:
1) Cryptocurrencies backed by other assets or yield.
2) Cryptocurrencies that function as payment and value store vehicles.
3) Cryptocurrencies with a specialized network application or utility value.
According to Kordez, most of the protocols hold value if they are actively used. The value of a protocol derives for the product cryptocurrency market value. It consists of currency velocity (degree of user activity), supply and demand. Also, demand and currency velocity should exclude the growth price speculations and measure only the actual demand. He suggests this formula:
MVp = MVc * Vc
MVp = protocol value.
MVc = cryptoasset value designed on the protocol.
Vc = velocity or the frequency of the actual cryptocurrency exchange.
Valuation challenges
For the vast majority of the investors, cryptocurrencies is still a relatively new niche. Therefore, current crypto valuation techniques face numerous challenges For example, let’s take bitcoin. It does not fit the traditional valuation models because it is partly currency, partly technology and partly commodity. It does not have cash flow, there are no estimated earnings and its history is still too fresh to establish reliable valuation models. Furthermore, other factors complicate crypto-projects valuation:
ICOs and tokens lack standard economic features. Unlike traditional securities, there is little regulation, utility value and data transparency.
Principal-agent problem. Cryptocurrencies do not have an extensive history yet. From what we have, it already shows that most of the tokens have a shorter lifespan than the projects themselves. Most of the initial tokens are distributed through ICOs, which creates a principal-agent issue.
“It is just like a commodity.” Many investors fail to apply the traditional finance analogies onto the cryptocurrencies.
Some of the crypto projects are unsuccessful. Consequently, it complicates the ROI forecasting process. Assumptions used for valuation equations may already be expired, so models like dividend-discount model put dividends into perpetuity. If the project lifespan is approximately five years, the valuation process can differ significantly.
No risk-free rate. Without a set risk-free rate, it is more difficult to discount future cash flows to the present. Moreover, it is hard to calculate it from the data, although some market-based interest rates exist in some exchanges. Even then, the practical data is hard to come by.
Impact of “Dumb money” behavior. Due to the broad scope speculations, price movements may not transmit actual economic signals, making it harder to recognize the real long-term economic value.
Systematic risk. Unlike traditional investment portfolios, crypto markets contain some level of systematic risk that cannot be diversified away. In simple terms, the industry is still fledgling and an investor undertakes both project and market risk with cryptoasset purchases. Hard forks, new crypto attacks, external regulations and other factors contribute to the systematic risk which is very hard to estimate considering the short time spans and industry characteristics.
Dependency risk. Many crypto projects are interdependent, inducing dependency risk to them. For instance, if ethereum blockchain is attacked, it will affect not only ethereum chain, but also the entire ecosystem built on it.
Novelty of the industry. Even though more than eight years have passed after bitcoins launch, the industry is still relatively new and fragmented. Most of the business models are still in development phase and our current aggregated knowledge is still unable to identify what are the standards for fair cryptoasset valuation.
Conclusion
In the end, it all boils down to this: what price should you pay for a cryptoasset? For a long time, investors saw one of the two coin sides: skeptics were sure that the value of cryptoassets has been almost non-existent. Cryptocurrencies have received harsh amounts of criticism since the launch of bitcoin and skeptical valuations claimed that the value will only remain there for as long as a marginal sucker is willing to buy them at a higher cost. Those who managed to see the other side of the crypto token saw that the value is way higher than a zero. In fact, recently Bitcoin itself has reached a significant milestone as it became valued at more than $100 billion, surpassing such big names as Goldman Sachs or eBay.
The difference between zero and $100 billion is somewhat bizarre. Eventually, it is up to you which side of the token you choose to see. It is evident that cryptoassets are not your traditional holdings and estimating its value can be somewhat tricky and risky. However, we live in the digital age, the age which moves away from the conventional means way faster than a speeding bullet.
