Valuing Cryptos: Market cap or DCF?

Yes, a DCF (Discounted Cash Flow) valuation for cryptos is possible! At least in principle.

Market Cap approach: Nice and simple, but what compares with what?

There’s currently a fair amount of writing around about Cryptocurrency valuations. It ranges from :

  1. the “it may be worth nothing’ school (which could be said about pretty well anything, by the way); through to
  2. calculations based on comparing the market capitalisations of Bitcoin to gold or similar; and then
  3. you also hear people say “of course, one can’t do a conventional DCF valuation’.

The market cap approach is perfectly reasonable, not least because it is quick, simple and easily understandable, though there are so many uncertainties (do we look at the ratio of the Bitcoin market cap to that of gold; do we bring in other cryptocurrencies on the numerator or a broader range of established assets to the denominator; do we adjust for whatever…) that it obviously gives an enormous range of possible answers.

But while a case can be made for comparing Bitcoin and gold, it’s less clear what coins like ETH and DOT, with their potential to take over most functions of global finance and a fair part of global logistics, might be compared to. A starting point might be the global financial sector plus all logistics companies, but that’s probably too broad in some ways and too narrow in others. Still, to give you an idea where it might lead, the market cap of global banks is around USD 6 trillion, while that of ETH and DOT combined is somewhat below USD 200 billion (end-Jan 2021).

A DCF would be much better defined, if it could be done.

There are income streams

So is a DCF possible? It’s clearly wrong to say that one “can’t” do a DCF, because all cryptos offer at least the potential for an income stream. There are a vast number of issues to be addressed in doing a DCF for crypto, but then that’s also true for almost every asset under the sun.

So, let’s look at some of the income streams that accrue, or may in future accrue, to cryptocurrencies.

Staking Rewards

The easiest and most obvious are staking rewards. These currently run at around 15% on DOT and 10% on ETH. If it was as simple as that, then we could do our DCF in seconds and given where fiat yields are, it would give an astronomical price.

But it’s not as simple as that: partly because staking rewards are calculated in various ways, so for example we know that the return on ETH will go down by about a third as more and more of the outstanding coins are staked; partly because if you are unlucky enough to validate a duff block, your holding could be slashed; but most fundamentally, because you are paid in the same coin that you have staked.

Fixed income investors will immediately think of PIK (payment in kind) bonds, which pay their coupon in more of the same, and which tend to have a bad name because they are, sometimes, issued by companies that don’t have any actual cash to pay out. A kinder, and perhaps more appropriate, analogy is with a scrip dividend, where a company pays dividends in its own shares, which might be good if the stock has growth potential.

In short, a DCF calculation based on staking rewards begs the question of what the coin will be worth in the long run, which is kind of what we wanted to know in the first place.

Supply-Chain and DeFi earnings as an anchor for DCF

Another approach could be based on DeFi (Decentralised Finance) earnings or, perhaps even better, earnings for operating real economy stuff like supply chains. Suppose there’s a smart contract that is used to power switches between a USD stablecoin and a Swiss France stablecoin. Or to trigger a payment from one company to another, in USD stablecoin, as soon as someone in a warehouse scans the barcode on an incoming delivery.

Whoever is doing the forex transaction, or the supply chain transaction, has to pay a fee. The fee will actually be paid in the cryptocurrency native to the blockchain, or chains, being used, so the transactor has to buy some of it to pay their fee. (Hopefully not very much – one of the points of doing all this is that ultimately, it’s meant to bring costs down, as well as improving security, transparency etc.)

Now, we could just wave our hands in the air and say that this “increases demand” for said native coin, and that’s already an interesting result, not least because that demand is linked to the volume of fiat-related transactions using the crypto world, implying that this is a source of demand that will rise over time.

But what’s also interesting is that the fee being paid is an income stream to the holders of crypto, that (unlike staking rewards) is linked to the value of the underlying fiat-denominated transactions. This allows, in principle, the calculation of DCF that will actually give a valuation measured in fiat for the relevant cryptocurrency.

I think that’s rather exciting. The trouble, of course, is that these kind of transactions haven’t started yet, or only in small quantities. So we can’t even begin to start doing the actual calculations, but knowing that they are in principle possible seems to me a fairly big step forward.

And like so much in the crypto world, it may well take only a short space of time before a theoretical idea like this becomes easily applicable.

An income for Bitcoin?

And what about Bitcoin? In itself, it has no smart contract capability so it can’t directly generate income of any kind, fiat-linked or otherwise. But as more links across different blockchains are built under the Polkadot system, it’s not too fanciful to imagine Bitcoin being used as collateral or in some other way on a different chain, and that might in some sense provide an income stream that can be assigned to it. (Note that as a conventional accounting matter, investors rarely assign any part of the return on a leveraged investment to the collateral used for the loan, but they ought to, because you couldn’t do the deal without the collateral.)

Bottom line: DCF is coming

DCF valuations are on their way! As the DeFi market develops even more (and despite recent stellar growth, it’s probably barely started) and as supply-chain applications appear, it will be possible to do DCF calculations. And these may help more investors to become comfortable with the concept of cryptocurrencies and start adding them to their portfolios.

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