Reveling the Valuation Mysteries of Cryptoassets

Introduction

In the fast-evolving world of finance, cryptoassets have emerged as a disruptive force challenging traditional investment paradigms. As investment professionals seek to navigate this dynamic landscape, understanding the valuation methodologies for cryptoassets becomes paramount.

The report “Valuation of Cryptoassets: A Guide for Investment Professionals” by CFA Institute provides a comprehensive roadmap for valuing cryptoassets, offering insights that can shape investment decisions in this burgeoning market.

Fundamentals of Valuation

Institutional adoption of cryptoassets faces challenges related to regulation, custody, and valuation, highlighting the need for regulatory clarity and bridging the gap between traditional finance and the cryptoasset ecosystem. Concerns among institutional investors include issues like fiduciary duty compatibility, custody challenges, market volatility, KYC/AML monitoring, and regulatory frameworks.

Despite these challenges, there is potential for significant investment in cryptoassets, with high-net-worth investors, cryptoasset hedge funds, and financial advisers showing the highest adoption and consideration of digital assets. However, a generational divide exists, with younger and less experienced financial advisers being more receptive to cryptoassets. Future preference to buy digital assets has increased among certain groups, while defined benefit pension plans show a decrease in future intent to purchase.

The Issue of Valuation

The valuation of cryptoassets has become a critical topic due to their growing popularity and adoption. However, the short period of time these assets have been in existence poses a challenge for developing robust valuation models. Unlike equity valuation models that have had decades to evolve, cryptoassets have a relatively short history, making it more challenging to establish valuation frameworks. Ongoing discussion and debate on valuation models are essential to eventually reach a consensus on a plausible valuation framework for cryptoassets.

Taxonomy of Cryptoassets

To facilitate a comprehensive discussion on valuation models, it is crucial to understand the taxonomy of cryptoassets. Different types of cryptoassets may fall under multiple categories, and a standardized classification system like “The Global Crypto Classification Standard by 21Shares & CoinGecko” is used to categorize cryptoassets. While additional categories like NFTs have gained popularity, limitations in data and reliance on qualitative features hinder a comprehensive review of their valuation drivers.

Valuation Models

Valuation Models for Smart Contract Platforms

To evaluate smart contract platforms, valuation models typically focus on assessing the intrinsic value of these platforms based on their business models and cash flow potential. Two main viewpoints are commonly employed in valuing smart contract platforms:

1. Viewing Smart Contract Platforms as a Business:
   • In this approach, the smart contract platform is evaluated as a business entity with definable cash flows derived from its business model. Transaction fees generated on the platform are considered a source of revenue.
   • The valuation model in this context would analyze the platform’s ability to attract users, execute transactions in decentralized applications, facilitate asset trading, and reward validators adding blocks to the blockchain.
   • Transaction fees play a crucial role in revenue generation, and the model would assess factors like fee structures, volume of transactions, and user growth to estimate future cash flows.
2. Viewing Smart Contract Platforms as a Network:
   • Alternatively, smart contract platforms can be viewed as networks where their value and growth are determined by network effects. Lower transaction fees can attract more users, leading to increased revenues and platform value.
   • This perspective emphasizes the importance of network effects in driving the platform’s adoption and value. The model would consider factors like user base, network activity, and the platform’s ability to scale and attract new participants.

Valuing Blockchains as a Cash Flow Asset

• One common method to value blockchain platforms is to treat them as cash flow assets where income is generated through selling block space.
• Block space is essential for any transaction on the platform and is paid for in the form of transaction fees denominated in the platform’s native asset.
• As demand for the platform increases, users compete for block space by offering higher fees, leading to revenue generation for the platform.
• Transaction fees are typically divided into base fees (burned) and priority fees (given to validators), with the platform’s characteristics and purpose influencing the fee distribution.

These valuation models aim to provide a comprehensive understanding of the revenue-generating potential and intrinsic value of smart contract platforms. By analyzing transaction fees, user growth, network effects, and business models, investors and analysts can make informed decisions regarding the valuation and investment potential of these platforms in the cryptoasset ecosystem.

Valuation Models for Decentralized Applications

Valuation models used to evaluate decentralized applications (dApps) focus on assessing the intrinsic value of these applications based on their revenue-generating potential and network effects. Two main approaches are commonly employed in valuing dApps:

1. Relative Valuation Approach:
   • Comparing dApps within the same sector or against their traditional finance counterparts using various metrics.
   • Metrics such as price-to-sales ratios, price-to-fees ratios, and market capitalization to net assets ratios are used to assess the relative value of dApps.
   • By comparing key financial and operational metrics, investors can identify undervalued or overvalued dApps in the market.
2. Intrinsic Value Approach using the Discounted Cash Flow (DCF) Model:
   • The DCF model is adapted to dApps to estimate their intrinsic value based on their revenue streams and growth potential.
   • Revenue generated by dApps through transaction fees, trading fees, interest charges, or premiums is considered as cash flows in the DCF model.
   • Assumptions regarding growth rates, discount rates, and other variables are used to project future cash flows and determine the present value of the dApp.

Valuation Models for DeFi

• Decentralized Finance (DeFi) tokens present unique challenges in valuation due to the nascent and evolving nature of the DeFi ecosystem.
• DeFi applications share characteristics with traditional finance business models, enabling the adaptation of traditional finance valuation models to DeFi.
• Revenue generation through fees (e.g., trading fees, interest charges, insurance premiums) is a common metric used for valuing DeFi protocols.
• Comparable analysis is conducted to assess metrics and relative valuation among DeFi protocols within the same category, allowing investors to identify investment opportunities based on relative value assessments.

Challenges and Considerations

• Valuing dApps and DeFi protocols requires a deep understanding of their revenue models, user base, network effects, and competitive landscape.
• The evolving nature of the cryptoasset ecosystem and the lack of historical data pose challenges in developing robust valuation models.
• Continuous research, analysis, and adaptation of valuation methodologies are essential to improve understanding and modeling capabilities over time.

By utilizing both relative valuation and intrinsic value approaches, investors can gain insights into the financial performance and growth potential of decentralized applications and DeFi protocols, enabling informed investment decisions in the dynamic cryptoasset market.

Valuation Models for Bitcoin

Valuation models used to evaluate Bitcoin, the pioneering cryptocurrency, focus on assessing its intrinsic value based on various fundamental characteristics and market dynamics. Several key valuation models are commonly employed to analyze the value of Bitcoin:

Total Addressable Market Approach

• The total addressable market approach values Bitcoin against comparable assets that exhibit properties of money, such as being a unit of account, store of value, or medium of exchange.
• Bitcoin can be compared with assets like gold, M2 money supply, central bank reserve assets, gross settlement systems, and remittances, assuming it can fulfill at least one of these monetary properties.
• The valuation calculation involves determining the level of penetration of Bitcoin in the target market and multiplying it by the value of the target market divided by the fully diluted supply of Bitcoin.

Stock-to-Flow Model

• The stock-to-flow model evaluates Bitcoin’s scarcity by comparing the circulating supply (stock) to the annual production rate (flow).
• This model suggests that assets with higher stock-to-flow ratios tend to have higher values, as scarcity is positively correlated with value.
• The stock-to-flow model has gained popularity for its ability to forecast Bitcoin’s price trajectory based on its scarcity dynamics.

Metcalfe’s Law

• Metcalfe’s Law values a network based on the square of its number of users, suggesting that the value of a network is proportional to the square of the number of its participants.
• Applied to Bitcoin, this model considers the network effect and user adoption as key drivers of its value.
• The model implies that as more users join the Bitcoin network, its value increases exponentially.

Cost of Production Model

• The cost of production model evaluates Bitcoin’s value based on the cost incurred to mine or produce each unit of the cryptocurrency.
• This model suggests that the cost of production acts as a floor for Bitcoin’s price, as miners would be reluctant to sell below their production costs.
• Factors such as mining difficulty, energy costs, and hardware expenses influence the cost of production model.

Strengths and Limitations

• Each valuation model for Bitcoin is derived from specific characteristics of the cryptocurrency and offers unique insights into its value dynamics.
• While these models provide theoretical understanding of Bitcoin’s underlying dynamics, no single model encompasses all aspects of the cryptocurrency.
• By considering multiple valuation models and their implications, investors can gain a comprehensive perspective on Bitcoin’s valuation and make informed investment decisions in the cryptoasset market.

Overall, the diverse range of valuation models for Bitcoin reflects the complexity of assessing the value of a decentralized digital asset and highlights the importance of considering various factors and methodologies in the valuation process.

Conclusion

In conclusion, the report “Valuation of Cryptoassets: A Guide for Investment Professionals” serves as a valuable resource for navigating the complexities of valuing cryptoassets. By addressing key issues such as institutional investment trends, valuation methodologies, and the taxonomy of cryptoassets, the report equips investment professionals with the knowledge and tools needed to make informed decisions in the crypto market.

As the crypto landscape continues to evolve, understanding the nuances of valuation models for smart contract platforms, decentralized applications, and Bitcoin is essential for unlocking the potential of this transformative asset class.