Yackadaisical Follow Jun 19
· 11 min read
The problem with using intrinsic valuation to crypto is that crypto currencies don’t typically generate any cash flows (save for staking rewards, but we shall ignore that for simplification for now).
Picture of confused Elon However, this has actually never stopped us traditional investors from applying the principles of intrinsic valuation.
The original application of intrinsic valuation was first used for bonds, which had pre-determined schedule of cash payments, then the methodology was applied to traditional stocks, which had uncertain but estimable yearly dividend payments.Now, intrinsic valuation is also applied to tech stocks, which usually don’t pay any dividends and don’t plan to for the foreseeable future.Consider the case of $Tesla, the total market capitalization (valuation) of Tesla stocks, which don’t distribute any cash flows to its stockholders now or any time in the foreseeable future, is valued at $673 billion.
Instead, traditional investors can use the idea of ‘distributable cash flows’, which supposes that if the company were to distribute its earnings as cash flow back to its stock holders, how much would these cash flows be.This makes sense as stock holders represent equity ownership in a Company, which in turn has a financial claim on the total retained earnings of that company.So, given that stock holders are entitled to potentially distributable earnings produced by this company, we can use this to model our intrinsic valuation framework even for stocks that don’t have actual cashflows.
Let’s apply the same concept to crypto.
Picture of happy Elon Currently most crypto tokens are ERC-20 tokens, which are either described as governance or utility tokens or both.Examples:
Apecoin: https://apecoin.com/about governance and utility token SAND token: https://installers.sandbox.game/The_Sandbox_Whitepaper_2020.pdf utility token For valuation purposes, governance rights can be ignored, as similar to the case of stock.In fact, the governance rights of shareholders differ drastically for each company with certain tech companies even creating A/B class share structures where certain shares will receive 10x the voting power.
Nevertheless, since intrinsic valuation is only concerned with the economic rights of the stock holder, our intrinsic valuation exercise can continue.
So we shall only be concerned with utility.
In the Sandbox whitepaper, the utility of the token is described as follows:
Players spend SAND in order to play games, buy equipment, or customize their Avatar character — and can potentially collect SAND through gameplay.Creators spend SAND to acquire ASSETS, LANDS, and through Staking.LAND Sales drive demand for SAND to purchase LANDS.Artists spend SAND to upload ASSETS to the Marketplace and buy Gems for defining Rarity and Scarcity
Watch the gameplay video to see all ownable products in the Sandbox We use a gaming crypto token as an example because its utility is most easily defined.Unlike Ethereum, Avalanche, or Solana, these blockchain use cases are still works in progress, gaming crypto tokens give us a much simpler valuation exercise.
Generalizing out from Sandbox’s definition, essentially crypto currencies give holders the ability to buy products (e.g.LANDS, ASSETs) created by the whatever applications supported by that blockchain platform.
IOW, crypto tokens represent a right to own these products , and the sum total of all crypto tokens (the valuation and market capitalization of the token) should represent the sum value of all the products that are created on that blockchain.
This is a major breakthrough.Although crypto currencies themselves have no cash flow, the products which crypto currencies entitle holders to buy certainly have value and therefore can be estimated using cash flows.
This should also intuitively make sense.Consider the case of a farm, that produces $100 worth of grain in one year.Suppose this farmer issues 100 tokens of a crypto currency called $GRAIN, which he will exclusively use as the only medium of exchange he shall accept in order to purchase his crops for this year (we will deal with perpetual cases later).
Ask yourself, is not the total value of this crypto currency equal to the US dollar value of the total value of the grain?
The insight is that we can use the estimated USD (or whatever currency you prefer) cash flow generated from selling the product exclusively tied to the crypto currency to estimate the valuation of the crypto currency itself.
How do we use intrinsic valuation? Typically, intrinsic valuation uses a discounted cash flow valuation (DCF).A typical DCF framework is summarized below by professor Damodaran:
We can calculate the intrinsic valuation for almost anything as long as we have these three inputs: 1) estimate life — which includes infinity, 2) estimate cash flows, 3) estimate discount rate.
See below case in valuation of Shell stocks (Source: https://www.youtube.com/watch?v=FJrdWOMvvx8 ), the key inputs are:
5 year forecast with Terminal Value reflecting sum total of all future years after year 5 FCFF — Free Cash Flow (understood as “distributable cash flow” as we mentioned earlier) for 5 years in the future and a terminal value capturing all years thereafter.FCFF is based on fancy adjustments (understood as why bankers get paid) to Shell’s operating income as reported in its income statements.
Discount value of 9.91% which reflects on the risk of the equity asset-class and the cash flow risk of Shell in particular What the DCF model does is: it discounts the free cash flow generated every year by a said discount rate, and then sums all future cash flows to arrive at the Value of Equity (US$165,477 million), and divide that by number of shares to arrive at a stock price (US$39.31).
We would then compare this intrinsic value with the current market price of the stock to determine whether we think this is a good investment.At the time of Damodaran’s analysis, Shell stock price was worth US$48, whereas his intrinsic valuation determined the stock price to be US$39, so the conclusion should be that it’s just a little bit overvalued.
The advantages of intrinsic valuation is obvious: it give us a methodology to calculate an asset’s valuation based on fundamentals, or cash flows in terms of real hard fiat currency, and avoids the traps of needing to refer to other market driven prices and valuations.
And of course, there are tradeoffs too.The key downside to DCF valuation is that you need to estimate future cash flows, and unless we have crystal balls that can look into the future, no one really knows what they are.However, as professor Damodaran always liked to say (to similar effect) — DCF just makes these assumptions about the future explicit, you are forced to confront them instead of retreating to the comfort of market forces.
For crypto, the advantages of intrinsic valuation far outweighs the disadvantages, since the asset is so volatile and currently lacks any fundamental bearings that help investors determine the value of the investment that they are holding.
DCFs at least can give investors some sense of whether the token is under or over priced relative to the market.
So, let’s do an actual DCF analysis on a real crypto currency Note for purposes of this blog, we will keep it simple, so we will be making numerous assumptions.You can add additional adjustments and different assumptions for your own analysis.
We shall continue to use SAND, the utility token for the Sandbox, as the example as games are relatively easy to estimate for future cash flows.In the case of Sandbox, the team has positioned the platform as a web3 alternative to existing games such as Minecraft and Roblox.
From the Whitepaper:
Our vision is to offer a deeply immersive metaverse in which players will create virtual worlds and games collaboratively and without central authority.We are aiming to disrupt the existing game makers like Minecraft and Roblox by providing creators true ownership of their creations as non-fungible tokens (NFTs) and rewarding their participation with our utility token — SAND.
Since Sandbox is positioned as a disruptor to Minecraft and Roblox, we can use the actual player spending in these two existing games as a basis for how we will estimate future cash flows for Sandbox.
Every year, millions of players spend millions, and now trillions or dollars, to purchase digital assets sold on Minecraft and Roblox platforms.Depending on our view of how successful Sandbox will be at replicating the success of Minecraft and Roblox, we can come up with a view as to the total value of all digital assets being created and used on Sandbox in the future as well.
Roblox discloses every quarter and every year, the amount of total bookings to Roblox platform.
Total bookings generally represent ~30% of all player spending on the Roblox platform, so using bookings disclosure we can derive total digital product sales on Roblox (we shall call this GDP as this closely mirrors the definition of gross domestic product — which is the total value of all goods and service provided in a country during a year).
From Roblox F-1 Prospectus Roblox was first released in 2006, and it took more than 10 years, before it reached $499 million in total bookings, or approximately $1.66 billion in GDP by 2018.By then, the game had more than 12 million in daily active users (DAU) and more than 2,000 million quarterly engagement hours.
Let’s assume Sandbox can catchup to Roblox 2018 levels of success in 5 years counting from the end of 2021 (about half of the time spent by Roblox to get there).And for simplicity sake, let’s assume GDP will double every year from now until 2025.Please note none of this intended as investment advice, we are just making simple assumptions to show the math .
Based on these assumptions, GDP of Sandbox will grow from $104 million in 2022 to catchup with Roblox 2018 levels by 2025 reaching $1.66 billion.
Now all we have to do is to discount all future cash flows and arrive at a present value per token.There are just two more variables we need to wrestle with, one is the discount rate, and the other is the terminal value.
Discount rates are actually surprisingly messy to calculate as they have to take into account asset class risks and particular risks of the asset in question relative to the asset class.We don’t have time to get into any of this today, for purposes of this exercise we shall just assume a discount rate of 20% (most equity discount rates are around 8~12% for reference) to account for high risk and volatility of crypto currencies.
Terminal value is based on a mathematical equation to derive present value of all future cash flows to infinity based on a fixed growth rate and discount rate.Again, for simplicity, we can assume a future growth rate of 5% in perpetuity and we already determined that the discount rate shall be 20%.
So plugging in all the numbers.
Let’s review our key assumptions
Sandbox becomes on path to Roblox 2018 levels in 5 years, generating a GDP of over $1.6 billion in 2026 and more than $2.3 billion in 2027 Discount rate of 20% The platform GDP shall grow 5% in perpetuity We arrive at present value of Sandbox’s total GDP of $7.7 billion, divided by 3 billion tokens in total supply, and we arrive at intrinsic valuation of Sand token price of $2.6 per SAND.
Since $2.6 per SAND as derived by intrinsic DCF valuation is higher than current market price of $0.8 per SAND, and an investor that believes the above assumptions to be true should find the current token price relatively attractive.Again, this is not investment advice, just a mathematical show case for how DCF valuation could be used.
Limitations of current methodology We have encountered obvious limitations to DCF valuation with regards to crypto currency valuation even in the blog.
It is unclear how to arrive at future cash flows or GDP figures for blockchain platforms other than games.
For blockchain games it is relatively easy, APE coin should represent aggregate value of all digital products to be created in the YUGA labs ecosystem.SAND should represent all digital products created and used on Sandbox.ETC.
However, the logic becomes very complicated in case of layer 1 and 2 tokens.For example, in case of Ethereum, the most obvious utility is to pay for Gas fees and purchase NFTs, but people also treat Ethereum as a general storage of value.In my mind, a storage of value still means that it represents the future utility of buying real products, but it is unclear what those products are for Ethereum in the future (since new use cases are still being explored).
The relationship between intrinsic value and token value is even more complicated for Bitcoin as Bitcoin’s use case begins to diversify into non blockchain native applications.How should we look at GDP when people actually begin to accept Bitcoin as legal tender in certain countries, or do these even matter when most major countries will still insist on using their fiat currencies.
2.It is unclear what is the correct discount rate to use for crypto currencies.
Intuitively, it makes sense to me that the discount rate must be higher than traditional equities as the volatility of crypto markets is much higher.
However, what methodology should we use to arrive at an exact figure? Traditional equities use CAPM (capital asset pricing model) to determine discount rates, but I am not sure if that applies in this case.
And finally, I would love to hear what you have to say.Please leave a comment below..