Does Value Exist in Crypto?
Why Token Valuation Is Important?
I am a crypto bull. I believe blockchains are valuable (read So Why Are Blockchains Valuable?). I think they can revolutionize commerce.
I am also a pragmatic investor. There is a chasm between the potential value of crypto and quantifying what that value could be. A bridge between the two is needed.
My time and research effort is spent thinking about how to value crypto assets. I am experienced in distressed, value, growth and venture investing. Heuristics from those investment styles apply to crypto. Some are irrelevant. New heuristics are emerging.
A discussion on why valuation is important is trivial to tradfi investors. Understanding value is so commonplace in tradfi it’s taken for granted. Yet in crypto, there is no concept of value. There is only price. Tokens are characterized as cheap and a good buy when their token price has fallen 80%. Ironically, tokens are not considered expensive and a good short when they’ve risen +1,000%.
Crypto investors are lauded for “hodling” and having “diamond hands.” The mindset is nonsense. You wouldn’t hodl other investments indefinitely. It encapsulates the immaturity of the industry.
An asset is cheap or expensive, a buy or a sell, relative to its value; not relative to its prior price. An asset’s value and price change. But they rarely change at the same time. They are often driven by different factors.
This is the first in a series of pieces discussing value. Starting with the most basic:
Why is token valuation important?
For six reasons:
Price ≠ value
Underwriting investments
Valuation drives returns
Developing a contrarian view
Portfolio construction
Required for capital inflow
1. Price ≠ value
The price of an asset does not always reflect its value. That is especially true for liquid securities and tokens.
How do we know price ≠ value?
If price always = value there would not be investments that generated higher than average returns. There would also not be investments that generate below average returns. Assets would be perfectly priced to reflect their value. Returns would be homogenous.
That’s clearly not the case. The wide distribution of investment returns proves assets are regularly mispriced.
How come assets are mispriced?
Assets are regularly mispriced because markets are inefficient. Information is not perfectly distributed. Data is interpreted differently. New industries emerge. Old ones perish. Technology disrupts.
Changing variables make it incredibly hard to price assets. Prices reflect the market's best guess of the value of the asset at a point in time.
Why are markets inefficient?
Markets are a collection of human opinions. Groups of humans are notoriously irrational. They violently oscillate from exuberance to doom. Extremes are often over reactions. In those moments, the price and value of assets can differ greatly.
Since price does not always equal value, we need to develop a mechanism to determine the value of crypto assets.
2. Underwriting investments
The purchase price is a key driver of a good investment. An investment can only generate above average returns if the asset purchase price is below its intrinsic value.
What is intrinsic value?
Intrinsic value is a basic concept of tradfi investing. It was pioneered by the 1934 publication of Security Analysis by Benjamin Graham and David Dodd. It was popularized by Warren Buffett. It is taught in business schools, investment banks and investment funds.
Historically, intrinsic value was determined by valuing a business’ tangible assets. For example, the total value of the real estate, equipment and inventory Acme Co owned was worth $100 per share. Acme Co’s price was $70 per share.
Acme’s price < intrinsic value.
Acme has the making of a good investment.
The definition of intrinsic value evolved with the economy. As the economy grew beyond manufacturing, businesses had fewer tangible assets to infer their intrinsic value. Intrinsic value was then derived from a company’s cash flow. Buffett only uses historical cash flows. Forecasting is too imprecise and optimistic for him. Cash flows are capitalized to determine the value of the overall business from which a per share intrinsic value is derived.
Intrinsic value evolved again when technology companies became more prominent. Historical cash flows were less relevant because tech companies grew so quickly. Investment analysts forecasted future cash flows, capitalized them and discounted them back to today.
At each iteration of intrinsic value, it became more subjective and dependent on the growth and discount assumptions made.
Intrinsic value equivalent in crypto
What is the intrinsic value equivalent in crypto?
Without an understanding of token value, how can we determine if a token is a good investment or not? How can we determine if a token price is below or above its intrinsic value?
3. Valuation drives returns
Valuation is less relevant in early stage venture investing. A great investment in early stage venture is based on:
Caliber of founder(s)
What problem is being addressed
How much are people affected by the problem (i.e. how much are people willing to spend to fix this problem?)
How many people are affected by the problem (i.e. how big is the total addressable market?)
There are no tangible assets and only limited revenue to value in early stage venture. About 30% of seed stage companies make it to Series A. Thereafter, the success rate of each next stage is roughly 50%. That means the chances of a seed company growing beyond Series B is 8% and beyond Series D is 2%.
Early stage venture investing is in the home-run’s business. Outliers drive returns. A good venture fund will have a couple home runs. A few will be singles, doubles and triples. The vast majority will be strikeouts. The best way to get more home runs is more at bats. That’s why a typical early venture portfolio has 50-100 investments. Studies show that a venture portfolio of 100 investments is the best way to generate outsized returns. There is a higher chance of a unicorn in a pool of 100 investments than 50. The outsized return of the unicorn will offset the loss from the additional 50 investments.
Highly diversified early stage venture portfolios reflect the fact that valuation is less relevant and nebulous.
Valuation becomes more relevant as a company matures. Later stage venture valuations are important, growth stage valuations are critical, mature and distressed valuations are paramount. As the company matures, the returns are predicated on management execution and the rest of the market coming around to your view. The latter is what moves an asset’s price from the purchase price to its intrinsic value.
Without an understanding of token valuation projects will struggle to raise capital required to grow from early stage venture to mature businesses. As a company matures, valuation becomes increasingly critical. The same will hold true for crypto projects.
4. Developing a contrarian view
An investor needs to have a contrarian view in order to generate above average returns. Without a contrarian view, an investor will be invested in what everyone else is invested in, which means they’ll perform in line with everyone else. By definition, they’ll generate average returns.
The analyst underwriting the investment is an outlier at first. The analyst thinks X, while everyone else thinks Y. As the company’s management team executes, more people start to believe X. Eventually, everyone believes X. The change in perception is what moves asset prices.
The astute analyst who believed X did not have to pay for the upside of X because the market believed Y. The intrinsic value of the company was below its price. Once the price was bid up by the market starting to believe in X, the price reflected the company’s intrinsic value.
There is a fine line between the courage of an investor’s contrarian conviction and the humility of being wrong. It’s only in hindsight that the truth emerges. In the moment, being contrarian and being wrong appear the same. An understanding of a token’s value affirms the investor’s conviction. Without understanding the value of an asset, it’s impossible to be contrarian.
5. Portfolio construction
Crypto investing blends the world of private venture investing and public market hedge fund investing. Crypto projects have liquidity events through token issuances at project inception or months thereafter. Traditional venture investing typically has a liquidity event 7 years after the seed deal. Private investors are thwarted into public crypto markets. As we’ve experienced and explained, irrationality and volatility run high in public markets.
Positions are marked to their market price every day in public investing. A fund manager needs to know how to act when a token drops or increases 50% in a day. Private investors need not worry about that. The price of their investment is not volatile. It rarely changes until a monetization event. There is not much a private investor can do if an asset drops in price; they’re stuck owning it. Public investors need to manage the volatility and can use it to their benefit. To do so, they need to have a firm view on the token value.
A private investor cannot dictate the size of an investment like a public investor can. Private investors get their allocated amount from investing in a private round. Public investors can size their positions however they’d like.
Psychology is more important in public investing than private. The constant price changes affect the investors perception of the value of an asset. Imagine how you would think of the value of your home if someone rang your doorbell everyday and told you the selling price of your home. And that value changed materially for no reason. That’s the psychological barrage public investors face. To endure it, a public investor needs to have conviction in the value of the assets in the portfolio regardless of their daily price gyrations.
To size positions accordingly an investor needs to understand the relative risk/reward of one position versus another. The potential risk and reward is driven by the difference between an asset's intrinsic value and its current price. As the price of an asset rises and approaches its intrinsic value, the risk/reward is no longer as favorable, all else being equal. The investor should reduce the outperforming position and rebalance into others.
Value is critical to portfolio construction. It informs position sizing. It allows investors to withstand the psychological barrage of public investing.
6. Required for capital inflow
Without valuation heuristics large allocators, such as pension funds, endowments, mutual funds and sovereign wealth funds will not allocate meaningful capital to crypto. The global asset management industry manages over $100 trillion of assets; about half is in the US. Venture made up $330 billion of the $50 trillion US asset management industry. Seed and early stage deals made up $18 billion (5%) and $77 billion (23%) respectively of the $330 billion deployed. The overwhelming amount of capital is invested in assets where value can be discerned.
The allocators representing the bulk of the $100 trillion of assets will not underwrite “Mooning” and “FOMOing” investment strategies. They are not repeatable. The head of a pension plan or endowment will not convince their investment committee to invest in crypto “because it’s going to the moon” or on the basis of “trust me, everyone else is buying this, we got to buy it and we’ll sell it before everyone else does.”
Tying it all together
Developing token valuation methodologies is critical for the evolution of crypto. Understanding value is paramount because price ≠ value. Value drives returns. Contrarian views are rooted in valuation. Portfolio construction requires it. Large allocators require it to deploy meaningful capital into crypto.
Valuation methodologies need to be broadly accepted by the market for them to impact token prices. If you are the only one that believes in a valuation methodology. It doesn’t matter. The rest of the market needs to adopt the valuation methodology. Once the market recognizes the token is a great investment its price will move toward its intrinsic value.
Securities Analysis introduced novel valuation methodologies in 1934. But the methodologies didn’t have an impact on security prices until decades later once the methodologies were widely adopted.
Valuation is one of the most interesting fields of crypto research. Stay tuned for more on the topic.
Stay curious.
Follow me on Twitter @samuelmandrew for my latest.