The Web3 Paradigm: Tokens (Part 2)

One of the most common concerns I hear from investors who avoid crypto is that they don’t know how to value it and therefore buying it feels like a speculative endeavour. This is a fair challenge. Decentralised networks powered by their own tokens are novel and complex. Projects building in the space are engaging in a simultaneous technological, economic, and social experimentation. Some may succeed to create significant wealth for the tokenholders while many will fail.

As was the case with joint-stock companies, it will take time for a commonly agreed-on valuation framework for crypto to emerge. Recall that Graham and Dodd’s Security Analysis was published 334 years after the formation of the East India Company in 1600. Although we are only 14 years on since the invention of Bitcoin, intuition around this new asset class has been building quickly. This article provides a summary of where we have gotten to so far on crypto valuation as an industry, as well as some further thoughts on the unique profile of crypto economics compared to traditional asset classes.

Why is crypto difficult to value?

Perhaps it is useful to break down the problem at hand. Why is crypto hard to value? My observation is that the difficulty primarily emanates from two factors.

First is that most cryptoassets are associated with networks and applications that are in the early stages of their build out. Crypto projects tend to launch tokens early in their development because the token utility is what activates the network’s full functionality (e.g. payment or collateral tokens), enhances the product offering (e.g. discount tokens) or enables the network’s decentralised decision-making (e.g. governance tokens). Projects that are initially VC-funded have been seen to launch their tokens after their Series B round. Simply put, valuing crypto is often akin to valuing an early-stage start-up building a two-sided platform, at least from a project’s maturity point of view.

Imagine trying to value Facebook in 2006 or Airbnb in 2011, at the close of their respective Series B rounds. Most traditional equity valuation methodologies would have been ineffectual in the absence of an established market or a proof point of how pervasive the emergent social behaviours – like sharing content with people on the internet or staying at a stranger’s house – will become. Conviction building at this stage is likely to be driven by a thesis formation around how the new market might evolve in the long run, analysis of existing competition (if any), and the quality of the team that is executing the vision.

This art-form evaluation process is often unfamiliar to investors in the public equity realm. With a growing proportion of technology companies choosing to stay private for longer, public market investors have become more accustomed to analysing businesses that have already figured out their monetisation strategy in a relatively established market.

The second (and probably bigger) reason for crypto’s valuation challenge is that crypto is a strange hybrid of capital assets and consumable/transformable assets. According to Robert Greer’s framework published in The Journal of Finance in 1997, traditional assets can be categorised into 3 superclasses:

Capital assets are assets that have an ongoing source of value. Examples are stocks (infinite, variable cash flows), bonds (finite, set cash flows) and real estate (infinite, variable cash flows). They can be valued based on the expected cash flows, discounted back to the present at the cost of capital.
Consumable/Transformable Assets (“C/T Assets”) are assets that have an economic value because they can be consumed but do not yield an ongoing value stream. Examples are physical commodities (like grain, wheat, oil, natural gas) and precious metals (like gold, silver, platinum). Their value depends on the supply and demand dynamics of the specific market.
Store of Value Assets (“SOV Assets”) can neither be consumed nor generate income, but nevertheless have value because people store their wealth in them. Examples include fine art, collectibles, fiat currencies. Certain SOV assets can overlap with other categories, such as Capital Assets (in the case of real estate) and C/T assets (in the case of gold). Often SOV assets have an arbitrary monetary premium beyond the utility of the asset.

So how does crypto fit into this framework? Tokens possess elements of C/T and capital assets. And whether certain tokens become SOV assets remains to be seen.

Ethereum: Hybrid of a C/T and Capital Asset

To illustrate how a token can be simultaneously a C/T and a capital asset, let us delve into Ethereum’s economic model.

In short, Ethereum is a two-sided platform that connects users of Ethereum-based decentralised applications (demand side) with an independent group of validators who commit their computing resource to help validate and settle user transactions on the Ethereum ledger (supply side).

When users interact with apps built on Ethereum, they pay transaction fees to the network. Transaction fees comprise base fees (which are algorithmically determined based on network traffic) and tips (for priority execution ahead of other transactions). Base fees are used to “burn” (destroy) the total supply of ETH, which creates deflationary pressure.

On the supply side, validators “stake” (lock up) 32 ETH as collateral to show their commitment to behaving honestly. In return, they gain rewards for processing user transactions. Validator rewards also come in two flavours: tips (passed on from the users) and new tokens issued by the network (which are algorithmically determined based on how much ETH is staked). New token issuance adds to the total supply of ETH, which creates inflationary pressure. The balance between the base fees that burn token supply and validator rewards that inflate token supply determine the net change in ETH’s total supply.

In the above economic model, we can see that ETH is

1) a medium-of-exchange token used to pay for transaction fees, and

2) also used as collateral by the validators to gain the right to earn fees from the network.

Under 1), ETH is a C/T asset because it is a commodity that is consumed to settle transactions on the Ethereum ledger. But under 2), ETH is a capital asset that provides future cash flows to the holders who “stake” ETH.

As seen from Greer’s classification, no traditional asset is simultaneously a C/T and a capital asset. This makes crypto a novel instrument for valuation purposes.

So how do we value crypto C/T assets and crypto capital assets?

Valuation Framework for a Crypto C/T Asset

Many tokens represent a proprietary medium of exchange in their own networks. In fact, as we saw in Part 1, nearly 70% of the top 100 tokens are used for payment. Payment tokens are digital commodities and thus fall under the C/T asset superclass.

To value a medium of exchange, traditional macroeconomics uses a simple formula called the equation of exchange:

MV=PQ, where

M is the total money supply (i.e. the market cap of a token)
V is the velocity of money (i.e. average frequency with which the token is spent/changes hands)
P is the price level of goods and services (i.e. price of a transaction)
Q is the quantity of goods and services (i.e. how much activity/transactions are conducted in that network).
PQ is the “nominal GDP” of the economy, or in crypto speak, how much transaction value is generated within the network.

Rearranging the equation to M=PQ/V, we develop the intuition that the market cap of a token is equal to its network’s transaction value divided by the frequency with which the token changes hands. Put another way, a C/T token gains value by having a larger use case (higher PQ) and a reason to hold (lower V).

Notice that having a larger use case is a necessary but not a sufficient condition for a higher market valuation. If the token is purchased purely to pay for the service, then the infinitely high token velocity will collapse its market value. This is widely known as the velocity problem. At equilibrium (i.e. after the hype/speculation dies down), most tokens are unlikely to be treated as money but rather commodities which are purchased to access a specific blockchain-based service. As such, a token buyer’s motivation could be to minimise the amount and duration held of the token, similar to how businesses aim to minimise inventory stocked on their balance sheet as part of their working capital management. Vitalik Buterin, the founder of Ethereum, attributes the token velocity problem to the “implicit cost” of holding the token. He writes:

“Let us now look once again at the economic effect on the users. What do users lose by using an application with a built-in appcoin[…]? The simplest way to express this is as follows: the “implicit cost” imposed by such a system on users is the cost to the user of holding those coins for that period of time, instead of holding that value in the currency that they would otherwise have preferred to hold. There are many factors involved in this cost: cognitive costs, exchange costs and spreads, transaction fees and many smaller items. One particular significant factor of this implicit cost is expected return.”

In the absence of an expected return, a payment token will suffer from the velocity problem which in turn will challenge the token’s value accrual. An exception to this is if the C/T token is successfully embraced by society as a SOV asset.

A SOV asset (like the dollar or fine art) commands a monetary premium purely because of the shared belief that the asset has and will continue to hold value. Such belief exists due to either the asset’s widespread acceptance or scarcity. Bitcoin (BTC) is a C/T asset that might be on the path to becoming a SOV asset; its 21m maximum supply has reinforced the “digital gold” narrative. If it becomes a legal tender in various countries, a portion of wealth stored in weaker government-issued currencies might find a new home in BTC.

Below is a simplified valuation exercise for BTC using the M=PQ/V formula. Assumptions are for illustrative purposes only. If BTC, over the next 5 years, can capture 10% market share of the high-friction remittances market and 3% share of wealth stored in gold and global money supply (excluding hard currencies like USD, EUR, CNY, JPY and GBP), then its implied fair price today would be ~$22,600 assuming a 50% discount rate. Notice that >99% of BTC’s fair value here is derived from the ‘store of value’ use case, with only a small residual coming from the ‘remittances’ use case. This is because the market size for storing global wealth is very large and the velocity associated with parking money (rather than spending money) is naturally low.

Valuation Framework for a Crypto Capital Asset

Crypto capital assets can often be found in networks that require supply-side participants to stake the native token as collateral to earn the ongoing fees paid by the demand-side. The valuation of such tokens can be approached using the familiar DCF (discounted cash flows) methodology.

Even so, the challenge of doing a useful DCF for a long-duration asset such as crypto should not be dismissed. Any equity analyst that has built a DCF for an early-stage company can attest to how much of the present value rests on/fluctuates with terminal value assumptions. In the spirit of striving to be “roughly right than precisely wrong,” one may prefer to simplify the valuation process to a multiples-based approach. In equities, there are arithmetically three value drivers:

1) Earnings growth

2) Multiple expansion

3) Share count reduction (implicit here is the company’s Return on Invested Capital. If returns are generated through sub cost-of-capital investment like pricey stock-based compensation or expensive M&A, share creep can be a painful headwind).

Multiplying 1), 2) and 3) together gives expected price return. The same framework can be applied to crypto capital assets. If we view Ethereum as a business that sells block space, analogous value drivers would be:

1) Transaction fee growth (in $ terms)

2) NVT multiple (Network Value/Transaction Volume, essentially like the P/E multiple)

3) Token supply growth

As shown above, ETH price in the last 3 years grew 9.1x from $130 to $1200 – a function of an exponential increase in transaction fees and significant multiple compression, accompanied by a relatively modest token supply growth. Predicting each component is obviously subjective, but this decomposition is simple and helpful for modelling the crypto network’s value accrual potential.

Some further comments on the three value drivers:

Admittedly, there is circularity in 1) since we must assume transaction fees in $, which fluctuates with ETH price. But the intuition is that as block space becomes more mainstream, users will become more sophisticated about how much fees they pay in $. Decentralised services ultimately need to be competitive (whether in cost or product differentiation) with centralised solutions.
As layer-1 blockchains mature, we will gain more data on 2) which will help build intuition about reasonable network multiples (Professor Aswath Damodaran, I’m looking at you!).
Many of Ethereum’s layer-1 competitors are currently heavily subsidised by new token issuance. 3) establishes that high token supply inflation without a corresponding increase in users/transaction fees could be a substantial headwind to network value over time.

Where Crypto Capital Asset Differs from Equities

Though we approach crypto capital asset using the traditional equity framework, a crucial point worth highlighting is that crypto is an economic system that rewards providers of work, unlike equity which rewards providers of capital. In equities,

Total return = price return + dividend yield

Barring any exceptional circumstances, dividend yield is paid out equally to all shareholders, who are capital providers to the business. In contrast, crypto’s total return could be thought of as

Total return = price return + work yield

Crypto’s dividend yield equivalent, which I call “work yield”, varies depending on what kind of tokenholder you are.

Remember Ethereum validators stake 32 ETH to be able to earn rewards. The act of staking is a crucial service, or “work”, provided to the Ethereum network. This is because staked native assets in a Proof-of-Stake (PoS) blockchain represent the level of network’s security. An attacker would need to accumulate 51% of the staked ETH to gain majority power to potentially threaten the smooth running of Ethereum’s consensus process. The more ETH staked, the harder it becomes for anyone to gain 51% of staked ETH, and the more secure the Ethereum network becomes. In this context, validator rewards are effectively an incentive mechanism to increase the network’s security. Tokenholders who add to network security (i.e. the stakers) benefit through higher “work yield” at the expense of those who don’t (i.e. the non-stakers). Tokenholders who don’t have the technical capability to be validators themselves can stake their tokens with validator-as-a-service providers, who charge a commission. Such tokenholders would earn work yield higher than the non-stakers but lower than the validators.

Let’s illustrate this using hypothetical numbers and familiar equity analogies. Ethereum’s “capital return policy” to its tokenholders is set-up as if:

Stakers are preference shareholders that are entitled to cash dividends (i.e. user tips) + scrip dividends (i.e. new token issuance). The two make up total validator rewards.
Non-stakers are ordinary shareholders
All shareholders can benefit from share buybacks (i.e. user base fee burn)

As can be seen above, stakers get a higher yield at the expense of the non-stakers. Specificially:

Staker’s work yield is 4.48%, made up of 0.56% cash dividend yield and 3.92% “scrip dividend” yield
A non-staker’s work yield is -0.5% due to the dilution from the “scrip dividend” (i.e. new token issuance) issued to the stakers.

In summary, crypto provides unified price returns to all tokenholders but varying levels of “work yield” depending on what type of tokenholder you are. This implies that those who provide work might have a different view of a token’s “fair value” to those who don’t provide work.

Additional commentary (warning: this section includes math)

For the mathematically-inclined, we examine Ethereum’s model for new token issuance to validators. It follows the formula:

New ETH issuance rewarded to validators is proportional to the square root of how much ETH is staked. This means there is diminishing incremental reward for incremental ETH staked after the network achieves a certain level of security.

Another way of seeing this is that dilution to the non-stakers starts decreasing beyond a certain amount of ETH staked (the numbers in the graph are based on the hypothetical example we used above).

Work incentivisation within a crypto network is modelled mathematically and implemented programmatically. Each system follows a unique model. For example Bitcoin’s issuance to miners halves roughly every 4 years. Ethereum’s follows a square root function. Crypto’s approach contrasts with a company’s typical dividend payout policy, which targets either a certain payout ratio or is non-committal like “progressive” or “under review.”

The effects of algorithmically-determined incentive mechanisms on participant behaviour is an ongoing experiment in crypto.

Conclusion

Tokens are distinct from equities, which arguably have been an inefficient model for capturing the intrinsic value of online networks. Equity value of an internet company is a function of the company’s ability to monetise its user data (i.e. advertising revenues), rather than the actual usefulness of its services to the users. This profit extraction model of equity can result in a dichotomy between the network’s stock market value and the intrinsic value of its products.

In contrast, tokens derive their economic value directly from user demand. Well-designed tokens can help align the incentives of the network’s various participant groups including users, tokenholders who provide work, tokenholders who delegate others to provide work on their behalf, and passive tokenholders.

A comprehensive valuation framework for crypto networks will undoubtedly take time to develop. Greer’s superasset classification however is a useful starting point for contemplating suitable valuation approaches for the different types of cryptoassets.

In summary:

Crypto C/T asset valuation can be approached using the Equation of Exchange.
Crypto capital assets with ongoing value flows to the tokenholder can be approached using a traditional equity framework.
Many cryptoassets are a hybrid of a C/T and capital asset, which adds to the complexity of valuing them.
Crypto networks are designed to reward participants more than passive capital providers. The notion of “work yields” was developed. Network’s compensation for work (e.g. validator rewards) is a programmatically implemented social contract that can feature as a type of yield in the total return framework.
Designing the network’s incentive mechanism for work is a mathematical modelling exercise. Social behaviours around different incentive models will take time to understand.