Robert Greer, author of By the way, what is an asset class?argues that assets lacking an objective measure of value and facing a supply constraint are more vulnerable to irrational exuberance, citing the “dotcom” bubble as an example.
Crypto assets today lack an objective measure of value among investors, much like emerging technology companies did in the late 1990s.
We can value any asset using two approaches: intrinsic or relative. Intrinsic valuation measures the value of an asset based on its ability to generate cash flow.
On the other hand, relative valuation methods, also called “pricing,” estimate how much to pay for an asset based on what others pay for comparable assets.
Investors can use the discounted cash flow (DCF) method to value a stock, but they won't use it for a work of art.
Likewise, we need to describe the different types of crypto assets to understand the differences we can expect in their specific value accumulation and valuation approaches.
In this regard, it is useful to classify crypto assets according to the three asset superclasses proposed by Robert Greer:
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Fixed assets: “A continuous source of something of value” (for example, bonds and stocks).
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Consumable/Transformable Assets: “You can consume it. You can turn it into another asset. This has economic value. But this does not generate a continuous flow of value” (e.g. physical raw materials).
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Store of valuable assets: “They cannot be consumed or generate income. Yet they have value” (for example, coins and collectibles).
Like Internet architecture, cryptoassets and blockchain technology have two layers: (1) infrastructure and (2) applications.
In his 2019 work, Chris Burniske classified crypto assets at the infrastructure layer based on the blockchain consensus mechanism:
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Proof of Work (PoW): In PoW networks like Bitcoin, the native asset (BTC) relies on a computationally and energy-intensive lottery called mining to determine which block of transactions to settle on the blockchain and reward minors. Therefore, they belong to the consumable/transformable asset superclass, as they essentially create “a native digital product in the form of a secure, globally accessible ledger space.” Investors can use the cost of mining production as a fundamental metric to gauge the lowest price of PoW crypto assets like BTC.
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Proof-of-Stake (PoS): In networks like Ethereum and Solana, validators must commit a portion of their capital – the “stake”, in this case, ETH – to access a recurring stream of value generated by the rules of the network. Therefore, they fall into the category of fixed assets and their value can be derived from the net present value of annual flows to validators using a DCF method.
Although we won't delve too deep into the application layer, we can apply the same fundamental principles by thinking:
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Governance tokens provide voting rights and represent ownership of the application. They are analogous to ordinary shares in traditional finance, therefore they belong to the class of fixed assets.
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Utility tokens determine the system economy as their sole function, which means they fall into the category of consumable assets.
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Non-fungible tokens (NFTs) are collectibles like fine art in their most typical form today, falling into the Store of Value category.
Intrinsic valuation: Ethereum
From a validator's perspective, PoS assets like ETH are akin to dividend yield-paying stocks, which means we can perform a DCF valuation by following four simple steps:
1. Estimate cash flows over the life of the cryptoasset
A. Transaction fees within the network accrue to validators. Likewise, fees are an indicator of revenue. Ethereum validators received $401.7 million in transaction fees (net after the burn mechanism) from January 28, 2023 to January 28.
b. Issuing tokens does not dilute the value of validators. Rather, they are entitled to new issues, in the same way that shareholders can receive stock-based compensation. ETH issuance from January 28, 2023 to January 28, 2024 was $1.5 billion.
vs. Total cash flows: a + b = ~$1.9 billion in year one.
2. Estimate expected future cash flows and lifespan of the crypto asset
A. Future Cash Flows: We propose a slight variation of the three-stage growth model to project Ethereum's future cash flows. Specifically, we anticipate an initial period of aggressive growth, followed by a gradual decline that will eventually stabilize at a more moderate growth rate.
b. Asset Life: In the case of public companies which, at least in theory, can last forever, stock analysts generally assume that cash flows beyond a specific point in time continue in perpetuity. Investors can apply the same logic to PoS crypto assets, but for simplicity we assume the lifespan of ETH will be 20 years.
3. Estimate the discount rate to apply to these cash flows
A. Minimum discount rate (9.9%): Over the past 10 years, the Invesco QQQ Trust ETF has earned a compound annual return of 9.90%.
b. Higher discount rate (21.9%): obtained using the three-factor Fama and French model (market premium, size premium and value premium).
4. Estimate the net present value (NPV) of cash flows using the parameters above
Assuming a 9.09% discount rate, the implied price per ETH today would be around $5,315, a 134% increase from the ETH price ($2,268) on 28 January 2024.
On the other hand, if we use a discount rate of 21.90%, the implied price per ETH would be **$1,349**, a ~41% decrease from the price of ETH, as of January 28.
Investors should interpret the results of this DCF valuation with caution and make their own assumptions regarding projected cash flows and discount rates.
The reason behind our approach was to be conservative and capture the high volatility of ETH in the discount rate in order to accurately reflect the risk of the asset.
Another implicit assumption of this approach is that the monetary premium of the asset (Store of Value) is integrated into the DCF.
Source: https://ark-invest.com/articles/analyst-research/bitcoin-new-asset-class
Intrinsic valuation: Bitcoin
When it comes to crypto-commodities, the marginal cost of production is essential because it sets the floor price at which producers (miners) are willing to sell. From the outset, it is crucial to emphasize that we are not suggesting that the price of BTC should be determined by its marginal cost of production.
This would be to adopt a labor theory of value which is manifestly false. Instead, marginal cost of production is a tool that can help investors estimate a lower limit price level for BTC and other crypto commodities.
Source: 21Partages
In 2019, Charles Edwards proposed a methodology to estimate the global average cost in US dollars of producing one BTC. The first element of the method is the Cambridge Bitcoin Electricity Consumption Index (CBECI), which provides an up-to-date estimate of the daily electrical load of the Bitcoin network.
Edwards estimates the production cost per BTC as follows:
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Calculation of the number of BTC mined per radius (based on miner rewards)
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Calculate the daily electricity cost to mine one BTC (daily electricity cost)
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Estimated global average “electricity cost to total cost ratio” = (electricity cost of Bitcoin)/(daily cost of running a Bitcoin mining business).
An investor can then calculate the cost of producing bitcoin as follows: (daily electricity cost)/(electricity/total cost ratio).
Finally, the cost of producing Bitcoin is compared to the “Bitcoin miner price,” which attempts to capture the revenue that BTC provides to miners.
Bitcoin miner price is calculated as follows: BTC price + (daily transaction fees)/(BTC mined daily).
When the price of BTC is lower than the full cost of mining one BTC, it indicates that Bitcoin miners may be in trouble and potentially incur losses in the short term.
The estimated global average cost of electricity to mine one bitcoin is $23,211.1, as of January 28, while the estimated global average total cost to mine one bitcoin is $38,685.1.
I repeat, investors should not interpret this range as the fundamental value of bitcoin, which is subjective, but rather as an estimate of its floor price based on miner profitability and subsequent behavior.
This article was first published in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, Click here.