How traditional equity valuation methods come short in crypto.
I’ve been observing the development of the crypto space on and off since 2012, though more actively participating in it only for the last 12–18 months. Like most, I haven’t been immune to the jaw-dropping numbers that are currently floating around. Both critics and avid fans point to a developing bubble, citing the ‘valuations’ that these crypto projects achieve raising multi-million funding rounds through Initial Coin Offerings often before even having a working product.
This below shows the market capitalisation of the top 10 largest tokens in circulation as of this writing:
I’ll spare you the math, it’s just over $100 billion (while the total for all crypto tokens is $115 billion). But what does that number actually mean? I’ve made some reflections on this below.
Taking a step back, equity is a security that gives its legal owner certain rights, above all the right to receive some form of cashflow from the underlying company. VCs generally own ‘preferred’ equity, a different class of it that allows them to veto certain decisions, get preferential treatment in an eventual liquidation, amongst other things; listed market retail investors typically own shares that may allow them to cast a vote while earning a share of the company’s profits through dividends. Theoretically, any valuation of an equity-like security can be arrived at via a discounted cashflow model by making some assumptions about its future cashflows and how risky the equity holder perceives they are.
What about token valuations?
By owning a token one has the right and the incentive to participate in an economy (existing or future).
As long as participating in such economy is expected to yield some sort of utility value to the holder of the tokens, the tokens will have a market clearing price that is a monetary reflection of such utility. To state the obvious, it does not reflect an equity ownership in a company. For example, the Siacoin token gives you the right to use some virtual storage space from a decentralised storage network. That’s valuable, in the same way as Dropbox users think 1TB of space is worth $100/yr (with the difference that there is no Dropbox Inc. behind it, but other users that earn tokens by giving up some of their disk space). If Dropbox’s equity is worth say $10b, that is the price some shareholders are willing to pay today to own the rights to its future cashflows. At the moment of this writing, the total circulating supply of Siacoin tokens is valued at $400 million. But what does that actually mean?
The example of the funfair comes handy here, so I will dwell on it at the risk of being very predictable. Imagine a funfair issues a limited number of tokens which customers have to buy in order to get into the various attractions. I’ll call them Funcoins, the default currency of the “funfair economy” (imagine it’s a country where everything is priced in Funcoins). Most intend to use the tokens to actually have fun, but inevitably there will be some speculators who just buy Funcoins to then resell them to other suitors in the expectation they can make a profit.
The funfair turns out to be super fun, so much so that at one point if you multiply the total number of Funcoins issued by the going price it totals a stupidly high number, say $1 billion. Does that mean that the funfair is ‘worth’ $1b? Most definitely not. So what’s worth $1 billion tangibly, and to whom?
It’s the present value of the expected utility (i.e. the fun) that all Funcoins will deliver to their holders.
So, does that mean that if I show up with $1 billion in cash at the door, I can have all the fun myself? This is where the funfair example comes short, as the funfair is actually a centralised economy owned by its equity holders who at the end of it end up with all of the Funcoins (minus the ones that got lost) and the fiat they collected by selling them. A ‘decentralised funfair’ would actually be one where anyone can participate as a ‘fun provider’ (earning Funcoins for that service) and/or ‘fun beneficiary’ (giving out Funcoins to receive it), with the economics flowing directly between the two parties. The decentralised funfair would have no employees nor middlemen, only utilitarian participants; there would actually be no end to it, as long as the economic incentives on both sides remain attractive enough. If I wanted to own all the Funcoins myself with my $1b in cash, I would remove all the incentives from the system for participants to provide and buy ‘fun’. The funfair economy would dry up and ultimately die and its Funcoins would be worthless. I would be left all alone, entertaining myself. This is fundamentally different from the equity world, where control actually warrants a valuation premium, not a discount.
In a decentralised economy, democratising (rather than concentrating) ownership via incentives creates value.
Tokens should not be valued in the same way a company’s equity gets valued, they should be valued as (potential) self-sustaining economies that generate utility exclusively for their participants. Because such economies are decentralised, i.e. they have no central authority taking a toll, the most liquid tokens in any economy should in theory ultimately prevail and that would constitute the best outcome for its participants. It gets a bit surreal, but, continuing along the decentralised funfair parallel, let’s imagine there are multiple funfairs where a fun provider or a fun beneficiary can participate: inevitably they would choose the one that provides the most attractive incentives (i.e. more fun, higher rewards). So ultimately there will only be one decentralised funfair left and its “fun token”, the most liquid one that delivers the most value to its participants. There are some arguments in favour of token interoperability and co-existence, but I will ignore them for the purposes of this post. This is another major difference from centralised economies where, thanks to their profit moats, incumbents manage to consolidate monopolies and deter new entrants, extracting economic value out of the system and ultimately creating a suboptimal economy for its participants (think eBay sellers upping their prices to make up for eBay fees, think Facebook showing you what an algorithm thinks will be more profitable, think about Western Union turning over $5+ billion a year…).
So when our jaws drop at some token’s market cap, we are immediately drawn to think that a pre-product company gets valued sky-highly and to call it a bubble. What’s actually happening is that the market is anticipating that the utility value of that economy / use case will one day be $x and that there may not be any other currency to participate in it, then applies some sort of discount rate reflective of risk to NPV it to today. Since most crypto tokens are coded to be scarce, a thriving underlying decentralised economy will result in the appreciation of its only currency.
It’s not simple to immediately grasp this idea for anyone used to valuing equity based on future earnings potential because it’s a whole new way of looking at value creation that requires a different level of abstraction.
It also helps to draw some comparisons: comparing crypto market cap to the equity value of all public and private companies (maybe $200 trillion in total?), or comparing it to global GDP (c. $80 trillion) would be apples to oranges. Some think that the M1 and (some parts) of the M2 money supply is the most meaningful comparable in the long run as it represents the total amount of cash and liquid assets sitting in savers pockets or bank accounts, which could theoretically be converted into tokens if all goods and services ended up being delivered through token-based decentralised economies. Globally, that’s anywhere between $40–100 trillion.
Assuming the M1 money supply is a decent comparable, $100b prices in for example that:
- A. % of it gets ‘tokenized’
- B. by year 
- C. at a % deflation rate (rough, but Sia claims to be 10x cheaper than Amazon S3, Google Cloud etc.)
- D. discounted to today at [30%] per annum to account for risk.
Depending on ones view about A, B, C and D, $100 billion can either be a dirt cheap option on a future decentralised Economy, or a tulip.
PS: I’m going to be thinking about assumption A next, as that’s clearly a major part of the value equation. If you have any thoughts on decentralisation potential of various economies please get in touch.