We have been doing a lot of research on cryptoassets lately – Bitcoin, Ethereum, Lumens and a whole assortment of other blockchain-based projects.We know that many of our readers are a bit skeptical about all of this, but we are going to set those aside for now.
We are big believers in this technology, but we readily admit that there is an awful lot of ‘noise’ drowning the space. One of the big problems when analyzing anything here is how to value any particular cryptoasset. (Another problem is terminology, for the rest of this post we are just going to call everything a cryptoasset, but we know not everyone likes this term.) Of course, we are not alone in facing this valuation problem, no one really knows what Bitcoin is worth, let alone the thousands of other more obscure assets. There has already been a lot written about this subject. For some background, for all things crypto, we suggest starting with Andresseen Horowtiz’s “Cyrpto Canon“, which has links to some great resources. A great place to start on the topic of valuation is investor Chris Burnike’s post, but that is just the beginning.
A key problem with valuing cryptoassets is that there is no readily agreed methodology available. For traditional financial instruments like stocks and bonds, the industry has been using the Discounted Cashflow analysis (aka DCF) for close to a century. Unfortunately, DCF does not really work for crypto assets, for the simple reason that almost no cryptoassets come with rights to cashflows. Cryptoassets are generally speaking something very different. Bitcoin is a special case as it is really intended as a currency, so valuing that is almost an ideological process. However, other cyrptoassets are generally some part of a wide network being used for a specific purpose. Ripple, XRP, is a network for moving money between institutions; Lightening is positioned as a medium for foreign exchange; Ethereum is a way to price and monetize compute transactions; and so on. So the question is not how to value a stream of cash flows but how to value these networks.
As Burniske’s post we linked to above lays out, probably the most common valuation method used today is something called the Equation of Exchange. This draws on macro-economic principles developed over the past few centuries, which to put it simply was originally proposed as a way of valuing currencies, money supply and entire economies. This method bases its valuation on an equation often written as:
MV = PQ
M is the value of the asset, V is the ‘velocity’ of the asset, P is the price of any transaction on the network and Q is the quantity of those transactions. Without getting into the weeds of it, one of the key takeaways from this model has been the notion that Velocity and Value are inversely correlated. That is to say the less an asset is transacted the greater the value of the asset, all else being equal. There is something decidedly non-intuitive about that. Those of us with experience in traditional valuation struggle to get our heads around this concept. Much of the criticism of this model revolves around how to measure velocity. And so far, we have yet to meet anyone who can really explain how this equation works intuitively.
Nonetheless, this methodology has become quite widespread, we have seen it cited in many discussions of particular cryptoassets. One of the affects of this has been a widespread belief that velocity is ‘bad’ for valuations. To the point that many crypto project designers spend a lot of effort to reduce velocity, often at the cost of usability of the token for its intended purpose.
If we were trying to write a balanced view of the Equation-of-Exchange methodology we could walk through why velocity erodes value. However, we are not going to do that for the simple reason that we really do not believe in this methodology.
To be fair, we are not experts in this. We are still deep in learning mode, and there are clearly people far more versed in this who have valid reasons for using the Equation of Exchange. Nonetheless, something about this approach just does not seem right to us. We see it as more of a method for measuring money flow, but not the actual ‘asset’ itself.
This simplest critique is that MV=PQ is not dynamic, it does not reflect changes in the variables over time. It is just a snapshot of a specific period in time, like using a company’s balance sheet and not its statement of cashflow to value the company. This post proposes a different equation to capture ways in which a network changes over time. And if it were just a matter of being able to model a variable system we could use that formula or some statistical variation of MV=PQ.
However, we think there is a deeper problem. The equation of exchange seems to value something different than what an investor wants to capture. To put it simply, we could look at a company’s revenue and calculate it as some percentage of a country’s GDP, but that would not be a workable method for valuing companies more broadly. MV=PQ, as we see it, is a way of measuring an economy, and using that to value the components of that economy strikes us as being as misguided as using percentage of GDP to value companies. As above, part of the problem is that MV=PQ does not capture the full value of the asset over time.
Unfortunately, at this stage, we cannot propose a viable alternative. The reality is cryptoassets are incredibly diverse in usage. There are already dozens of categories of these assets – financial transactions, storage, compute, identity, store of value, smart contracts, and many more. This is not the same as valuing companies across industries using the some common method. It probably makes more sense to treat each cryptoasset as a software application, that is the stated purpose of most of them. In this light, each cryptoasset needs to be valued on a somewhat bespoke basis. What problem is it trying to solve? What is it replacing? What advantages does it bring and at what cost?
In the future we will likely have to develop different valuation methodologies for different types of crptyoassets. Some of these are straightforward, some are impossible to value today.
As Betteridge’s Law would tell us, the answer to the title of this post is ‘No’, no one is really clear how to value cryptoassets today. This should not lead to despair. Caution perhaps, but not despair. It is possible to value an indivdual software project, but as of today, there is no common framework capable of capturing the diversity of all cryptoassets.