Lessons From the Meltdown: a Value Approach to Token Valuation

In the aftermath of the 1929 crash in stocks and bonds, following a once-in-a-generation trauma, arose a whole new school of financial analysis that would blossom out 50 years later. In hindsight, one can say that financial analysis sprang out of the ashes of financial markets in the 1930s, before being applied by people that came to be known as quantitative analysts then security analysts. 

We owed it to a handful of minds, chiefly among them Benjamin Graham and David Dodd with their seminal work Security Analysis and later The Intelligent Investor by Graham, spearheading the Value Approach (championed by Warren Buffett and most funds today). People painstakingly learned the art (and not science) of valuing securities and paying attention to the fundamentals of businesses or economic forces underpinning the financial products they had been serendipitously buying so far. 

It did not erase the chances of undervaluation, overvaluation, crashes, fads, and manias, but it certainly limited them compared to the abyss of the 1920-1930s. 

The elusive crypto-universe has been deeply insulated from the Value Approach since its inception, partly by lack of knowledge of its techniques (most quants or tech people are not trained in Value Analysis) and partly because of the arrogant posture that “this time is different” attached to cryptos. However, some cryptos or tokens are securities, and others are closer to commodities or currencies to which elements of fundamental analysis and value investing (like “buying below the intrinsic value”) can be applied.

The blockchain-crypto industry needs a Graham and Dodd moment if it is to reconquer the heart of investors (and convince professional investors) after the recent 2 trillion USD debacle. 

From the Prysm Group (working with Wharton) to Arca, there are people investing significant brainpower, time, and resources into the matter. From my vantage point of view between Paris and New York, I see new axioms to bring to the industry.

Securities valuation never claims to be a science with a definitive answer: it is more akin to an Art, with a different range of values, sensitivity analyses, and scenarios, in order to ascertain a certain intrinsic value below which buying the security is interesting (undervaluation), and above which selling the security is an opportunity (overvaluation). The difficulty for crypto or token lies in the varying or hybrid nature of the token: sometimes a security, sometimes a utility token, it can combine elements of both. It is sometimes as elusive as the Schrodinger cat in quantum physics.

As a result, the fundamental analysis process in the crypto universe must start with the determination of the nature of the token. Tokens are often just another part of the capital structure for companies. If equity represents on a claim on profits after debt service or cash flows, and bonds a claim on assets, tokens are usually a claim on a platform customers or usage growth, or intangibles. They are a way of rewarding stakeholders and customers, but in fine are underpinned by business fundamentals. 

Only a few cryptos, such as bitcoin (BTC), are closer in nature to a currency or a commodity (in the US, the commodity watchdog is poised to regulate cryptos and not the Securities Exchange Commission (SEC)). But most tokens are the third part of the capital stack for a business.

When a token can be described (sometimes legally qualifying as such) as a security token, it is a proxy on a business, with a token issuance used as early venture capital fundraising. In that case, all elements of the traditional discounted cash flows analysis can be applied. A token can then be valued as the fractional part of a business, based on product market fit and cash flows. 

In addition to discounted cash flow (DCF)  (where the discount rate will be a venture capitalist hurdle rate), comparable (peers) can be used based on several metrics: here, only the sagacity of the analyst can define the equivalent to the price-to-earnings (PE) or price-to-book ratios used for stocks. Sometimes, the adjustments are minimal. I will cite a few of them.

A pure price-to-earnings ratio exists only when the crypto has a mining system: one can then compute the market value of the token relative to miners’ earnings.

In most cases, the Network Value to Transactions (NVT) ratio is more relevant: it compares the market value to transaction volumes. In addition to a fundamental approach, it also values the token based on a usage or utility value or as a medium of exchange. The same can be said of the Price-to-Metcalfe ratio, comparing the market value to the number of addresses. 

The equivalent of the dividend yield used to compare yield stocks will be skating mechanisms, while the stock buyback equivalent is the token burn. Each token has its own metric, and you need to figure out inputs and run sensitivity analysis about what is happening within the network: inputs and sensitivity analysis are significantly more important than the price target itself. In the absence of protocol revenues, the net supply burn is the best gauge of free cash flows. In decentralized finance (DeFi) (with total value locked) and gaming, the earnings forecast is the simplest tool to project future growth and discount it back to the present.

Under the common term of utility tokens, there are, in reality, pass-through tokens (tokens that grant to their holders revenues, rewards, or network benefits) and asset-backed tokens (deriving their value from a collateral that can be ascertained). The situation is more complex for currency tokens, or medium of exchange, such as bitcoin. The only popular valuation approach here has been the Quantitative Theory of Money: it is but a mere indicator in our opinion, albeit flawed: long abandoned by economists, it has 2 endogenous variables that make any valuation exercise tricky.

We have been more successful for currency tokens in using a Price to Utility Ratio (see research from Liu and Zhang), where the Utility is defined as follows:

Token Utility (U)= (token velocity*staking ratio)/(price volatility*dilute rate)

It incorporates all utilities a crypto provides as a currency i.e. a store of value, a unit of account, and a medium of exchange, and values the crypto as a token or currency for a mini-Nation or closed economic system.

Investment Analysis and Valuation, with a value or a growth approach, independent or coupled with technical analysis, is still in its infancy in the crypto industry. 

If we want to put behind us the chaotic volatility of these new financial instruments, we have to rise up to the challenge and develop the analytical tools and frameworks built for stocks more than eighty years ago.

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