Seeking Uniform Valuation for Crypto (part II)
By Sandro Gorduladze, Head of Research (s.gorduladze@hashcib.com), and Rustam Botashev, CFA, Lead Analyst (r.botashev@hashcib.com), at HASH CIB
Acknowledgement: We would like to express our gratitude to the think tank of industry professionals put together around this valuation framework. The fact that investors and analysts representing the leader firms in crypto investment are part of this effort — providing feedback, participating in discussions for this research — gives us hope that we may find the approach that becomes universal across the industry. Here is the full list of participants in our Valuation Framework Group.
Our special thanks goes to Chris Burniske of Placeholder for helping us arrange a physical meeting for the group, resulting in this follow up publication.
This is the second article covering the development of a uniform cryptoasset valuation framework. At this time of unprecedented global liquidity injections and market rollercoasters assets are no cheap again and attractive opportunities are vanishing. While still relatively small, crypto is no different from other asset markets, but even less efficient. Industry pundits have long called for broader investor adoption of digital assets. We believe robust valuation model to be one of the key elements to that. The presented fundamental approach should equip the readers for choosing between the undervalued and merely inflated crypto assets.
After publishing the first article that we prepared with the help of a global forum of prominent crypto investors, we conducted a roundtable to solidify approaches we could agree on and help further develop those that were less unifying. The roundtable was co-hosted by the venture firm Placeholder in their New York offices in November 2019 and was attended both physically and virtually by members of the group.
This is almost a final step in our journey, as we complete the principles behind the crypto asset valuation modelling. The next step will be to create example valuation spreadsheets for each specific kind of tokens. Whether it has a PoS or PoW consensus-based token economy or a combination of the two, and whether it is a Layer1 chain or a Middleware protocol/dApp or hybrid network with multiple properties. The principles discussed below should hold for any kind and a combination/interaction of those and we intend to prove or improve it with the third article in the series.
Valuation Proposals
During last year’s group roundtable meeting we discussed the six proposals for valuing crypto assets. We highly recommend you to check Part I to get a better understanding of the proposals and the rationale behind them. It will help you navigate through this article much better.
Proposal 1. Classify the features or properties, in other words use cases, of different crypto assets rather than assets themselves.
Proposal 2. Use a single model for all types of crypto assets: bring DCF, Equation of Exchange (EoE), Store of Value (SoV), and any other valuation method proposed/improved on with time for crypto under one roof. Get rid of the abandoned approaches without having to re-build the model from scratch.
Proposal 3. Determine the value flows into the asset generated by each of its use cases (features) separately, but then attribute a summation of those inflows to the whole network[1] and all of its tokens, regardless of how each token is actually used.
Proposal 4. Value crypto assets using Discounted Value Flow, which is the NPV of its Future Value Flow[2].
Proposal 5. Account for the costs (including physical) to run blockchain networks.
Proposal 6. Disregard future issuance (inflation) when valuing a network at any specific period. And to derive value of its native token for that exact period, consider only tokens which have been issued by then.
While almost all proposals inspired active discussion during our roundtable, only a few were unanimously accepted or denied — facing different degrees of support and opposition. Overall, we believe that our methodology is still far from being widely accepted and becoming mainstream. But the more conversations we have about it and more people try to implement it and help us improve it, the more sense it makes. Below we briefly present the main counter-arguments to some of the proposals and our expanded answers to them, as this process helped us refine the proposals and get to a more robust set of principles.
We can proudly call the first two proposals generally approved. Majority of the group members agree that classifying the features rather than the assets makes a lot of sense. The logic to make a single model rather than value variously classified crypto assets with different models for each class was also accepted by the group.
Proposal 3
Disputes started at the third proposal. Some group members argued that attributing value flows into the network to all of its tokens equally isn’t always correct. For example, in blockchains with weighted voting systems (WVS), token holders, in some cases even with minority stakes, may have disproportional power. Therefore, the value flows attribution should account for voting power of tokens, according to that comment. This concern has already been addressed as the problem for disproportional power distribution in WVS is not unique for crypto assets. Such voting systems are the most widespread and have been around for ages — in parliaments worldwide, in joint stock companies, etc.
To value an enterprise, we attribute the cash flow to the whole entity, to all of its shares. The reason is that it’s not the shares that have disproportional voting power, but certain stakes in those shares. Therefore, the premium must be assigned to certain stake sizes, not to a single share. Why should we approach it differently for token valuation? In other words, the correct way to value tokens is to attribute value flows to all the tokens equally and only then assign a premium to the governing properties of coins as it is done so for the shares of a company.
To our knowledge the controlling premiums are assigned arbitrarily based on historical deals and we are unaware of any precise mathematical methods to quantify them. However, we welcome the efforts to develop a scientific methodology to calculate the premiums.
Another argument was that governance should be valued as a separate feature. We disagree. Governance for the sake of governance means nothing, we believe. It makes sense only if it‘s able to influence future value flow into the network. Governance is implicitly included in valuation when we assume that this property can attract more users, allow faster adoption and higher market share and thus, increase value inflows. We do the same when forecasting cash flow for a company with better management than its peers.
Other than for the argument on governance, Proposal 3 was accepted. Having laid out our counter-arguments we believe there isn’t much to debate about, as investors wanting to apply higher price tags to certain networks with governance mechanics can simply do so using our approach. One can just reflect it in their value flow assumptions going into the model.
Proposal 4
Proposal 4 discussion raised a few issues. Deriving blockchain value solely from the sum of discounted value inflows was strongly opposed for Bitcoin. The argument was that Bitcoin has a monetary premium on top of the total of value inflows, received from its use-cases. We agree that it has a premium, yet this premium is to the other existing coins not to Bitcoin’s value flows. This premium is simply the discounted value flow from Bitcoin Store-of-Value feature — the feature, which practically none of other coins possesses. We described how to calculate SoV value flow in Part I.
Another argument put forward in relation to Proposal 4 was that our discounted-value-flow method does not include accumulated mining cost for PoW networks and as such, is incomplete. Some roundtable participants shared the market-wide belief that the cost of mining creates a price floor for valuing Bitcoin. This view derives parallels from commodity markets where cost of production can create psychological price floors from supply-siders. We strongly disagree that accumulated mining cost may serve as a price floor for PoW chains.
Regardless of how much one spends to create any asset, bitcoin included, zero is its price floor at best. An asset can even get a negative price, effectively turning it into a liability. This concerns not only commodity derivatives (e.g. WTI futures) but real assets as well. Imagine a hopelessly loss-making factory having to pay severance packages to its employees before being allowed to shut down operations. Additionally, PoW networks’ output stays constant no matter the input, resulting in ever-changing cost basis for miners — it is much more volatile than that of any commodity.
We believe that while both arguments provided against Proposal 4 merit attention, they don’t really contradict our approach. More so, answers to those arguments illustrate that Proposal 4 not only allows to fully capture the value of a crypto asset derived from its use cases, but also isn’t a subject to fluctuation — as opposed, for example, to the very volatile production costs for PoW networks. Thus, we consider Proposals 1 to 4 so far successful in proving their validity, as the counter-arguments don’t really contradict but rather help explain them.
Proposals 5 and 6
Both Proposals 5 and 6 were discussed concurrently, with the latter turning out to be the most controversial and occupying the majority of our conversation. Unlike Proposals 1–4, the 5th and 6th ones do not work universally across all types of blockchain networks. Therefore, it makes sense to go through them again, specifically considering the outcomes of applying them to different types of networks.
Conceptually there are three types of blockchain-based networks/protocols:
a) Middleware protocols or dApps on top of some underlying blockchain, usually considered a Layer1. They have PoS-like or PoW-like token mechanics.
b) PoS blockchains, or similar mechanisms where the supply-siders, i.e. providers of the underlying functionality of a network, must stake their tokens to participate in validation.
c) PoW blockchains, where the supply-siders, miners, run special machinery that does “the work” to participate in validation. Mining does not involve use of the network’s tokens.
For the sake of abstraction we can say that fundamentally each network consists of four actor groups: the protocol itself (the encoded rules of how the network functions), suppliers (validators/miners/keepers etc.), investors (holders/traders), and users. Think of this as of a company, which consists of its legal embodiment, its employees, shareholders, and customers. We consider the supply-siders separately from the protocol, much as we consider company employees separately from the company, even though they are the ones delivering its product. For the purpose of this analysis we need to look closely at value flows between the protocol, the suppliers and investors, as it affects valuation.
Proposals 5 and 6 for Middleware/dApps
Applying Proposal 5 to middleware protocols/dApps is a straightforward exercise. The costs to run middleware/dApps consist of the expenses needed to keep the underlying software running and updated. Physical or similar costs to run middlewear/dApp networks, like running nodes, are incurred by the Layer1 blockchain on top of which they are built. With the proliferation of sharding/ cross-chain technology and complex interdependencies between blockchain-based digital services, we expect physical costs to come into play for middleware/dApps, as they will need to pay their own supply-siders (shard validators, collators or other types of keepers) and/or pay for external digital services. However, for the majority of existing dApps those costs are kept on the level of Layer1 they’re built on. Same applies to tokens of one network being “wrapped” and used on another one (e.g. different bitcoin tokens on Ethereum).
In addition to physical and similar (infrastructure-related) costs to run middleware/dApps there are also costs associated with software development and maintenance. It’s irrelevant here whether developers get their remuneration in tokens from the protocol via some vesting mechanism or from the network’s treasury or governing body — mechanics don’t matter. What matters is these costs are value outflows for the middleware/dApp we evaluate, so should be accounted for as such.
Proposal 6 applies for middleware protocols and dApps in a very direct way since they usually do not have independent issuance and as such, inflation. One just needs to decide what number of tokens to use to derive value per token — the circulating supply or the total supply. For the middleware and dApp networks that may have their own issuance Proposal 6 applies as it does to separate blockchains and depends on how they are secured (via PoS- or PoW-like mechanics), as described below.
Applying Proposals 5 and 6 to PoS Networks
Given that the suppliers on a PoS blockchain must hold its native coins, they are also investors. At the same time, investors get their share of block rewards and transaction fees if they nominate validators. In other words, investors act as suppliers as well and are incentivized by the protocol to do so. Therefore in PoS and PoS-like networks (including Middleware/dApps), we can consider the following actor groups of the network: the protocol, service suppliers and investors - a single unit. And this unit represents the network we are evaluating. Users are not included here, like customers of a company.
Flows between unit members don’t affect valuation. Only external value flowing to or from any of the unit’s members constitutes the value of the overall network. For instance, while transaction and other fees go to the suppliers, holders may see a pro-rata share of those fees. Every holder in a PoS-like network is entitled to a “revenue” share. If a holder opts out, they gradually incur a loss in the form of the network’s inflation and missed share of the transaction fees, getting the benefit of immediate token liquidity in return.
Similarly, a value outflow from any of the unit’s member groups is a cost borne by the whole unit. For example, the direct physical cost to run the blockchain is carried by the validators alone. Yet investors nominating validators assume their portion of this cost as a charge from the validator. Therefore, those costs are attributable to the whole unit and should be accounted for in the valuation as per our Proposal 5.
As said, only value flows coming into the unit or going out of the unit should be accounted for. Whatever value circulates within the unit is irrelevant for valuation. Block rewards paid out of the protocol to the suppliers do not “leave” the unit, and thus, do not affect the valuation of the network. Therefore, issuance/inflation in subsequent periods is irrelevant for a PoS valuation at any specific period T, according to our Proposal 6. We should not discount the impact of future inflation into the current valuation of PoS-like networks because once investors buy in, they are eligible for the block rewards and therefore, not diluted.
By stating that block rewards are irrelevant for a PoS-like network’s valuation, we don’t state that they are irrelevant to a single token’s value. Quite the opposite. A single token’s value is inversely proportional to the number of issued tokens. At any given period T, a single token’s value equals the ratio between the network’s value and the number of issued tokens at T. If the network’s value is V1 and the number of tokens is N1 at period T1 and V2 and N2 at T2, then a single token value is V1/N1 at T1 and V2/N2 at T2. An investor who bought n1 tokens at T1 and participated in validation will have n2=n1*N2/N1 tokens at T2. Her holding was n1/N1*V1 at T1 and n2/N2*V2=n1/N1*V2 at T2 — i.e. her total holding’s value doesn’t depend on the token issuance.
Believing all holders are able to participate in validation via staking and receive rewards is a rough assumption. This is very much a simplification. Yet, starting from a simple mental model one can always make it more complex depending on particular network’s tokenomics. For example, one may assume a certain participation rate from investors and account for it in the model.
Applying Proposals 5 and 6 to PoW Networks
Proposal 5 and 6 as applied to PoW networks turned out to be the most controversial topic during our roundtable. Unlike PoS, PoW network suppliers should not be considered part of a single unit together with the protocol and investors. First, miners are not required by design to hold the network’s tokens to be able to “work” for it. And second, just by holding these tokens investors have no chance of getting a share of block rewards or transaction fees from miners. Therefore, the network unit, which we need to value, consists only of the protocol itself and its investors. Miners represent an outsourced support function.
Transaction fees don’t affect the value of the network. These fees are paid to the miners via the blockchain and hence, represent both inflow and outflow which cancel each other out.
The physical costs of running the PoW network should be ignored since those costs are assumed by “outsiders” — miners — and do not represent a value outflow from the network unit. The cost that the unit pays via its value outflow is block rewards going to the miners in the form of newly issued native tokens, i.e. inflation. This makes Proposal 6 inapplicable to a PoW network valuation, as we should consider effects of future issuance on the value of the network and discount them back.
In the networks where miners receive only part of the full block reward (say, 60% as in Decred) — only that part counts as the cost-related value outflow from the network. Additionally, part of the block rewards that goes to treasury to support the network’s development operations should also be accounted for as costs (e.g. another 10% in Decred, as the remaining 30% goes to validators — internal players in its hybrid consensus system — and should not be accounted for as cost under our approach to PoS value flows).
It was pointed out during the roundtable that only if the miners are never holders, they could be left outside of the unit being valued. We don’t make such an aggressive assumption and we don’t have to. Miners are often investors, especially in the blockchains whose tokens are perceived to have SoV properties like Bitcoin. However, it makes no difference for the valuation who the actual parties behind the abstract actor groups of the network are. What matters for our approach is the value in- and outflows regardless of who is behind them. While holding tokens the miners are concurrently “wearing both hats” being both investors and service providers. That way the value inflows that they bring as investors offset some of the outflows that go to them as service providers.
All in all, given the endless types of tokenomics, valuations should be fine-tuned case by case. Having outlined a high-level valuation approach in general — for the community to accept it as a principle, we encourage everybody to apply it to real cases to prove its robustness or help evolve the model into something we can all be satisfied with. There is a long path of adoption ahead and we want you to participate. Feel fee to reach out if you would like to contribute to our Valuation Framework Group and look out for more details and model examples from us in the future.
[1] We use the word “network” here broadly, meaning any blockchain-based network/protocol/app, irrelevant of its place in the blockchain stack: whether it is an underlying protocol, a DApp built on top of it, or what is often considered a middle-ware protocol. So, in this context, the term covers any cryptocurrency/digital token network.
[2] We adopted the concept of DVF from Chris Burniske.
