How to Value a New Crypto Asset
For the last few months, I have been thinking a lot about how to value, or at least gauge, whether a newly released crypto asset is trading at a price that favors purchase, or perhaps sale, if we are looking a few years down the road. The standard way of doing this analysis is by measuring a securities’ free cash flow into the future and discounting it back to today at an appropriate rate, basically valuing tomorrow’s income at today’s prices. By dividing this metric by shares outstanding we get an approximate price per share (or per token in our case). We are essentially aiming to buy the security at a discount of what reasonable analysis suggests the whole enterprise will make in the future.
Crypto assets have measurable free cash flows. They can be measured as staking rewards, mining rewards, and some other ways developers have found to incentivize users to provide services to the network. These free cash flows can be used to calculate the current return on investment (ROI) for the network and using a reasonable discount model, project growth into the future and thereby “estimate” whether buying a token today makes sense given our future projections for the growth of this token. The issue with this model arises because of crypto assets’ radical volatility.
The key insight I believe that i have made to crypto asset investing, is the observation that tokens which throw of this free cash flow (staking rewards, treasuries, etc.), and do so reliably into the future, will tend to appreciate over the long term, at the very least on par with inflation and most likely increase by at least an order of magnitude. This for the simple reason that because of these free cash flows, tokens will continue to be used and thus developed and as price climbs from these two factors, a virtuous cycle will ensue since price appreciation of each token will lead to higher free cash flows.
However, in a market where crypto prices can fall by 90% on a whim, in the short term, this sort of virtuous cycle is not enough. If users are not careful and do not have the ability to stick with it (crypto markets are highly cyclical) they may lose most of their money very quickly. To combat this phenomenon, we must acquire tokens with a large margin of safety (the lowest possible price). A difference in price acquisition of a few dollars today will have outsized effects on our returns five years from now. Even if free cash flows are high by fiat standards (high staking rewards and a high token price in fiat terms), if we fail to acquire our tokens with a large margin of safety, we are on very shaky ground.
In previous work, I suggested that buying tokens as close to launch as possible would be a favorable strategy to securing as close to a rock bottom price for the asset as possible. This observation was based on my experience in the market during the ICO era of crypto investing in 2017. This idea is now largely irrelevant. In today’s post-ICO world, where token offerings are extremely competitive and highly limited, other metrics of pricing are in order. I have found two metrics which I believe are useful at gauging a good entry price for a newly released token.
The first of these metrics is the token price relative to the market leader, in this case, Bitcoin. When I started investing in alternative crypto assets back in 2012-2013, Bitcoin had a near 100% measure of market dominance; today that number approaches only 40%. But Bitcoin still has the largest market capitalization of any crypto asset, currently approaching 1 trillion dollars, it remains the market leader. My insight is that we should be able to take Bitcoin (or the lead cryptocurrencies market capitalization if you are reading this from the future) and extrapolate from it a reasonable high and low ranges to aim for in any crypto asset purchase.
In my research, I have come to the conclusion that 1% of Bitcoin’s market capitalization is a good “moderate” price target for any crypto asset a few years after buying it. At the current 1T market cap for Bitcoin, I would be targeting 10 billion dollars as an average crypto network’s estimated market capitalization a few years after launch. This can be adjusted up or down depending on the quality of the network under analysis, but 10 billion seems like a good target and would currently put our cryptocurrency on the top 20 by market capitalization. This is not exactly “aiming low,” but it also makes sense because our investment philosophy dictates we only invest in the most outstanding projects; a much lower target could be used if we are less stringent about selection.
On the other end of this, I would generally like to make no less than ten times (a ten bagger) on my crypto investment over 5 years. I am being very conservative here as our investment philosophy generally aims for 100-1000 baggers. This would suggest that we aim to purchase our assets at or below 0.1% of Bitcoins total market capitalization, currently that number would approach 1 billion dollars. That is to say that if we find a viable (by criteria explained throughout my writing) token that is currently trading at a price that gives it a market capitalization of less than one billion dollars this is a smart buy. Sale territory would approach once we have made ten times our money, or at 1% of Bitcoin’s market capitalization, whatever comes second.
I would like to note again the point that this is a highly adjusted model. My investment strategy leads me to invest about once every 3 to 4 years, but I do so heavily, and in highly vetted projects. These projects (such as Mina recently), by their nature, often have much more favorable economics, with buy ranges around 0.05% of Bitcoins total market capitalization. This is my personal target, and it makes a huge difference. It is just a lot more rare than the numbers we are currently using.
We have just discussed the economic (dollars and cents) way to value a crypto asset, there is another, equally compelling mode of network analysis. I believe that the ratio of active nodes on the network, divided by market capitalization, is a good metric of health, adoption, and investment potential for a network. The higher the number, the better. I have observed that networks acquiring market share and climbing the market capitalization charts, are generally adding to their node count, or that it at the very least keeps up with price appreciation. This makes sense, as a token increases in value and new adopters compete for rewards, they put up nodes and begin to mine and stake that asset. Today’s model for launching crypto assets is largely favorable to this analysis.
Going back to Mina, like many other contemporary crypto assets, prior to launch it established a healthy test network by incentivizing validators to join the genesis event by rewarding them with tokens for completing in pre-genesis qualifying challenges, thus assuring themselves that the network would be both robust, and manned by quality operators on launch day. This type of crypto launch is currently standard, basically a “tokens for nodes” exchange, and it is highly amenable to our analysis.
I suspect that although there is likely a lower bound in terms of how many nodes are operating in an asset per dollar of market capitalization, to make a favorable investment; it is likely more important that this number is not in decline. Clearly a network which is adding nodes on a regular basis is best and reflects growth, but we are also bound to analyze more mature networks in our travels, networks which have reached equilibrium for any given wave of adoption, so stability is also welcome. Declining node count and increasing market capitalization likely signal an important bubble, and both a declining node count and declining market capitalization, in earnest, are not healthy signs for any network. This metric can be monitored rather easily using project specific tools and on a monthly basis.
These two ideas are based on considerations of risk. Risk refers to the risk of loss of capital, that is that your investments will become worth significantly less than what you started with. By purchasing tokens at rock bottom prices, and keeping an eye on the health of the network by measuring the node to market cap ratio, you are taking steps to protect your capital by objective measures of value now as opposed to discounting the future. It is extremely hard to find objective ways to value recently launched crypto assets, they do not closely resemble any other early stage assets commonly analyzed by investors, such as biotech companies or IPO stocks. Buying a crypto asset at a rock bottom price and in a growing network, are close predictors of an investment’s margin of safety, no guessing needed.