Crypto Relative Value
A Method to Triangulate Crypto Value
How to value crypto assets?
It’s a question I spend a lot of time thinking about. It’s an on-going research theme of Crypto Clarity (read Does Value Exist in Crypto?). It’s a discussion I love stimulating. It’s a conversation that is gaining ground as fundamental investors target crypto.
Pioneering ways to value digital assets is one of the things in crypto that I am most excited about. I view it like propagating fundamental securities analysis long before it took hold. The seminal value investors manual, Security Analysis authored by Benjamin Graham and David Dodd was written in 1934. But it wasn’t until the end of the 20th century that their principles were applied.
Fundamental analysis is emerging in crypto markets. It will become increasingly important as markets mature and become more sophisticated. The adoption of valuation methodologies should occur faster than Graham and Dodd’s work did.
So…how to value crypto assets?
There are three valuation types, one of which is detailed in this article as a methodology to triangulate crypto asset valuation.
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3 valuation types
There are three types of valuations used to value nearly all financial assets in the world. A financial assets is something that creates economic value.
1. Absolute value
Absolute value methodologies derive a specific price for an asset. Absolute value methodologies include balance sheet value of an asset and discounted cash flow analysis. A balance sheet valuation infers what the value of a tangible asset such as a piece of equipment or real estate is worth. A discounted cash flow analysis forecasts a company’s future cash flow to determine its value today. Multiples based valuations are simply a shorthand for a discounted cash flow. In any case, a specific value at a point in time is inferred.
Absolute valuation methodologies can be applied to crypto. There are two preconditions to using them:
Some form of cash-flow or equivalent needs to be generated by the protocol.
Cash-flow equivalent value needs to accrue to token holders.
Unlike traditional securities analysis, these two preconditions are not apparent at all protocols.
In Crypto DCF (Non)-Sense: How a DCF is (ir)-relevant for crypto, I explained the shortcomings of applying DCF to crypto and how a DCF could eventually be useful.
2. Relative value
Relative value methodologies derive the price of an asset relative to another asset. Unlike absolute value methodologies, a discrete target price is not inferred. Since the inferred value is relative to another asset, the derived valuation fluctuates with the volatility of the reference asset.
Credit (meaning bonds, loans and their respective derivatives) are valued on a relative value basis. Discounting the future cash flows of Microsoft or applying a multiple to its earnings will not infer the value of its bonds. Microsoft’s bonds are priced relative to comparable bonds. Microsoft’s credit health, determined by its leverage and coverage ratios, covenants and business outlook, informs how its bonds are valued.
I started my career as a credit investor. I analyzed bonds of different companies. I determined that a given bond was a good buy because its credit metrics were favorable relative to its comparable set, yet the bond in question traded 500 bps wider than its comparables. That’s tradfi speak for the relevant metrics for the bond in question were the same as a bunch of other comparable bonds, yet the bond in question traded at a 10% yield whereas the comparable bonds traded at 5% yield. My view was that the 500 bps delta would compress. When it did, the price of the bond I bought went up (bond prices and their yields are inversely correlated, when the yield goes down the bond price goes up). I never actually inferred what the absolute price of the bond I bought should be. I only inferred its value relative to a subset of other bonds.
Credit is priced relative to interest rates. When interest rates move, the price of the bond moves. But, all else remaining the same, the 500 bps spread stays constant. An investor generates alpha when, in the example used, the 500 bps spread compresses. That’s why the absolute price of the bond is less important. It fluctuates daily with interest rate moves. What matters most is the spread the bond trades at relative to its reference asset. A widening or tightening of the spread is what drives credit returns.
Currencies are also priced on a relative value basis. There is no discounted cash flow or earnings multiple that can derive the value of the US dollar. The US dollar also can’t be valued in US dollars. Currencies are valued relative to other currencies. The strength or weakness of the US dollar is relative to the Euro, GBP, RMB and others. It’s a reflection of the economic health of the US economy relative to the economy of the country’s currency the US dollar is being compared to.
Credit and foreign currency markets are the biggest in the world. The value of the US credit market (including treasuries, mortgage-backed securities, corporate bonds, municipal securities, federal agency securities, asset-backed securities, and money markets) is $53 trillion. Global FX markets trade $7.5 trillion of volume per day. The largest markets in the world trade based on relative value. Relative value methodologies are commonly used.
Crypto lends itself to relative value methodologies.
3. Cost curve
Commodity production cost curves drive commodity prices. Commodities are priced at the intersection of the marginal unit of demand and unit of production (see chart below). The price of the commodity increases as demand increases because the marginal cost of production is higher. Additional marginal capacity is inefficient costly production. The price declines when demand drops because only the most efficient low cost producers, those at the bottom of the cost curve, produce.
Tokens of Layer 1 blockchains have commodity attributes. They could conceivably be priced based on the marginal cost of validating. If that were the case, Layer 1 token prices would be much lower. The cost of validating is minimal. Alas, these assets also have store of value and productive asset attributes, which make them more valuable than commodities.
Crypto relative value
Crypto can be valued on a relative value basis. The most obvious example of relative value is ETH valued relative to BTC. The comparison makes sense because the two assets share store of value properties. The concept of relative value extends beyond the two notable assets.
I posit that Layer 1 blockchains can be valued relative to Ethereum. Much like my prior credit analysis, Layer 1s can be benchmarked on usage metrics and their value relative to ETH used to infer the value of a Layer 1 token.
Usage metrics to benchmark include Daily Active Addresses, Daily Transactions, TVL and fees.
These metrics, amongst others, can be used to assess how Layer 1s are performing compared to one another. Trends in underlying metrics can be spotted. Those trends can then be compared to how the value of a Layer 1 token in question compares on a relative basis to Ethereum’s market cap.
Solana case study
Solana became a compelling relative value investment subsequent to FTX’s collapse. SOL token price declined 70% in the wake of FTX’s collapse. The SOL token was crushed for two reasons:
The market knew FTX/Alameda owned a lot of SOL that would be dumped.
Rumors swirled that Solana developers were abandoning the chain.
The first reason was exogenous. The selling of SOL by FTX, Alameda and other traders front running the sale did not impact the underlying Solana technology.
The second reason proved false. A discerning crypto analyst knew intuitively that a wave of developers abandoning Solana overnight was unlikely. Solana is not an EVM compatible chain. It is not easy to port a Solana app to another chain. The switching costs are high. Developers would not cavalierly leave. The underlying usage metrics, including github developer commits, evidenced that developers had not left in droves.
The charts above do not illustrate a material change in Solana’s operating metrics. Yet Solana’s market cap as a percentage of Ethereum dropped to 2.5%. Solana had traded at 6% of Ethereum prior to FTX’s implosion and as high as 15% in its heyday.
The market had oversold SOL. Solana’s valuation could be underwritten on a relative value basis. If the market was comfortable pricing SOL at 6% of ETH prior to FTX debacle, and FTX’s implosion was an exogenous one-time event, SOL should trade back to 6% of ETH, a 2x investment. SOL subsequently traded back to nearly 5% of ETH.
Triangulating valuation
There is not one way of valuing crypto assets, just like there is not one way of valuing non-crypto assets. Valuing assets is based on a triangulation of methods. Relative value is one such method that can be applied. In the case of Solana, it was the most appropriate to apply in that period.
Relative value may also be useful for valuing Layer 2s and potential apps. Exploring commodity cost curve valuation may prove to be a useful exercise to find a floor price.
Crypto assets are increasingly lending themselves to fundamental analysis because of the metrics that can be tracked, the value created and the value that accrues to token holders. The community needs to share ways of thinking about valuation. Crypto Clarity will continue to be a leader in the field.
Stay curious.
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