Evolution of Cryptoasset Valuations: In Theory and Practice - TOKEN2049 Singapore 2023

All right, thanks for sticking around. Uh we are going to dive into to valuation. It's a topic uh that Chris and I have been talking about for a long time. So, I thought to to set the stage, I just kind of describe how we met. And this is back in in 2016.

So, I was a I was my background as a professor, sort of a starry-eyed assistant professor thinking like, I'm going to develop valuation models for crypto assets. And I started I was like, well, I need some data. So, I started cold emailing. I cold emailed Overstock and Coinbase and others. And Coinbase got back to me and they're like, "Dude, we're not giving you any data.

But, we do know a guy who's thinking about valuation models like you are, and you should meet him." And they introduced me to Chris. Thank god. I was able to speak with someone reputable. But yeah, why don't you tell us what you were doing at the time?

Sure. Well, I was at Ark Invest at the time. Um mostly covering public equities, but also um had a sleeve of my focus in cryptocurrencies. And at that time, the fixation was really around how to value Bitcoin. And um what we came up with was to invert the equation of exchange in an unorthodox way.

So, the equation of exchange um really dimensions an economy. Uh on the demand side of the economy, you have MV, so the monetary base multiplied by the velocity, equal to the supply side of the economy, which is PQ, so the price of goods and services multiplied by the quantity of goods and services. And the very simple, yet, you know, controversial thing we did at Ark was to divide PQ, the supply side of the econ of the economy, by the velocity of money to solve for the necessary size of the monetary base. And I think it's, you know, an informative exercise. It allows you to dimension the variables of the economy.

Um it's not terribly predictive, but I'd say probably the bigger issue is it's useful primarily for currencies and most crypto assets are not currencies. Right. So, I remember spending a lot of time on on MV equals PQ uh going through some of the models around like ICOs, the very early ICOs. This was kind of late 2016. And I guess, you know, then, I mean, fast forward, we get to 2021.

2021 like blows up all the models that we're working on, right? So, Ponzinomics takes over and none of this stuff works anymore. And one of the things that we realized, you mentioned like most crypto assets are not currencies. They might have a currency-like element, but they kind of got other things going on as well. And I think one of the big learnings was like these things really maybe they're isn't going to be a unified valuation model for all crypto assets because crypto assets are so different.

So, how do you think about valuing something like Bitcoin versus Sol versus ETH? Totally. So, here I rely on some work from a guy by the name of uh Robert Greer, and he developed three super classes of assets. So, you have capital assets, consumable transformable assets, and store of value assets. Your capital assets tend to have a value flow of some kind.

And so, it can be, you know, equities, bonds, income-producing real estate, or stake-based assets. You know, a proof-of-stake asset has a value flow that accrues to the staked asset. And so, I would think of that as a capital asset. And a capital asset, you can go through some net present value calculation to back out, okay, the summation of all these future value flows uh discounted to the present, you know, what is that theoretical value? And so, that's a pretty well-understood science, and you know, you're more versed in that science than even I am.

In the consumable transformable landscape, that's more your standard commodities. And I would say probably the most useful um science there would be the cost of production. So, Bitcoin tends to bottom around the marginal cost to produce um another unit of BTC. There are some, you know, issues with that methodology cuz you can have uh basically downward mining price spirals, which would reduce the cost to produce BTC, but we we don't generally see that. And then, the third bucket of within the superclasses would be store of value, which is very subjective, more art than science, I would say.

The last thing I want to add is um valuation frameworks are most useful, I would say, in bear markets or in in times of duress or just pricing, say, the base value. They're not great at uh predicting the extent of human excess, like 2021 or 2020 uh 2017, or even 2013, because there um things tend to get so out of hand that there's not really a science to explain what's going on. 100% agree with that. I think, you know, one of the big learnings has been just the behavioral component. Mhm.

Um to all to all like I guess what we found is whether it's MVPQ or some of these others, like these are better sort of like frameworks for thinking about value than necessarily something where you're going to get a very precise answer. It's like a It's like a false sense of precision. Totally. You get from actually attaching numbers to these things. And the other thing is like these assets can evolve over time, right?

So, like take take Ethereum, right? So, now we have a staking rate, we have cash flows, like we can use like a DCF or an NPV model to kind of like back in to a value for ETH, but you never get to the anywhere really close to where the price of ETH trading even now in the bear market. And so there's got to be in addition to the casual component like a store of value or money-ness component. Yes. How do you think about like assets developing more of that over time?

Yeah. So, I think this stems from the programmable nature of crypto assets where they're quite a bit more flexible than our traditional physically occurring assets or even traditional financial assets. So, if you look at something like ETH, I believe the Bankless guys took this idea that ETH has capital asset, consumable, transformable, and store of value characteristics to call it the triple point asset, right? And so, you pointed out, you know, if you were to do an NPV calculation of staking off staking yield of ETH, it wouldn't sum to what ETH's current value is. Um and that's because ETH also has some consumable, transformable component where, you know, it's used as a gas within the network, but probably most importantly, it has this store of value characteristic, right?

A money-ness, people call it ultra-sound money, and that is where it's a lot more art than science, right? Um and so, you do have to take into account the full picture of the crypto asset. Um and then also, you know, I I would add to this entire conversation the study of market structure. And so, you know, the longer I'm in markets, the more I believe that a lot of things are determined by flow dynamics. And like, if you look at even valuation science within equities, it's been the death of value investors for a very long time who have been, you know, 20 years predicting the demise of Amazon because it's, you know, doesn't always operate profitably, it's not issuing dividends, but Amazon grows at such a rate and people are hungry for growth in this environment, and then it also becomes a matter of the market structure and the flow dynamics around the asset, right?

And in particular, I mean, both in a bear market and a bull market, I think you have to be conscious of, say, the um the the base at which the holders are underwater or in the money. Um because that starts to determine a fair amount of how the asset is priced as well. Yeah, so let's dive into that because there's, you know, I think one of our beliefs is that the assets with the strongest community, right? Like community is sort of like this really important component of the valuation of these assets and sort of like how that evolves over time, and many of the strongest communities, they have one thing in common, even though the assets might be very different, they created a lot of wealth in public. Totally.

Bitcoin has that attribute, you know, like the XRP army, the LINK Marines, like even NFTs like Squiggles and Punks, like Punks you could claim for free, right? Then, you know, they're worth like six figures now. So, like uh how important is that component of community or kind of like building wealth in public and how do you think about that with regards to valuation? Yeah. Well, one one easy heuristic is bear market to bear market, you want your committed holder base to be in the money.

Um and so, you know, this would advocate for launching a crypto asset at a at a relatively low valuation, and I actually think a time like now is a great time to launch crypto asset. If you look at Ethereum, it launched uh in the middle of 2015, which was the bear market of 2014 and 15. You look at something like Solana, launched in 2020, which is really the bear market of 2018 to 2020. And the good thing with um launching in the midst of a bear market. You start at a low basis.

You have broad access, so lots of people can accumulate the asset. It's not just the evil VCs like you and I. And then, you know, if everyone gets to rise with the asset as you pointed out, let's say the asset goes 100x. Then, if the asset sells off 95%, you're still up 5x from the prior bear's valuation. And so then, you know, there's a wealth effect that goes with that.

There's, you know, lots of social dynamics where you have your social army that defends you in the public. And that is a much better setup than say someone who goes for a crazy valuation, you know, listing in the middle of a of a bull market and then basically trades down. Yeah. And so And then going back to say market structure, I think a really useful valuation metric there would be realized value. So realized value being the summation of all coins of a network at the last time that they transacted.

And so it basically starts to show the assumption within realized value is that at the last transaction of any coin, that was when, you know, the coin changed hands or was used in in some sense. And so if you look at realized value, that that's, you know, basically the the cost basis of the holder base. And you look at market value, that's the current value of the entire network at the current market price. And so if you divide market value by realized value, if that's above one, your holder base your holder base is in the money. If it's below one, you know, they're in the red.

And I think that, you know, right around one would be say your equilibrium price. And I think we'll see more focus on market value to realized value over time cuz it is very quantifiable. And like for example, if you look at um first cycle networks, like if you looked at ETH say in 2016-17, um its market value to realize value, that ratio is very high. If you look at Solana in its first cycle, that market value to realize value is very high. But then as a network matures over time, you start to see a dampening of that ratio um because you don't have, you know, as crazy moves.

And so you have the market value trading more closely to the realized value. Yeah, fascinating stuff. So we'll we'll zoom out, we'll get out of the weeds a little bit and think more just about the psychology component cuz you mentioned something that was that was really interesting, which was like now would be a great time to launch a crypto asset. Now we know that sort of bear markets are usually like the ideal time to deploy capital, but human psychology is like the opposite, right? So like bear markets are when everybody wants to retract.

How do you as like an investor, right? Cuz this is true of both public and private markets. How do you kind of like get over that psychological kind of like um sort of inclination to like pull back and reduce deployment during during periods of lower valuation like this? Well, um maybe I'm just weird, but I get most excited um environments like the one we're in. But I would say that um like if you So in in anybody's first cycle, you're kind of on the roller coaster and your emotions are on that roller coaster and you're a little bit say uh beholden to whatever's going on in the market, that's dictating your emotions.

But if you reflect after your first cycle, um it can set you up to be proactive for the next cycle. And so long as you're a little bit of ahead of the market, then, you know, you're taking profits, you're making sure that you have, you know, some stack for the rainy day that comes. And then when that rainy day or year or, you know, 18 months does come, it can be rather exciting because you've stored, you know, the a fair amount of dry powder in order to deploy in that environment. Yeah, so there's this super just getting ahead of it. Yeah.

Warren Buffett quote, right? Like be greedy when others are fearful and be fearful when others are greedy. And that's like I keep coming back to that is like inspiration to just like basically moving the opposite direction of the crowd. Well, and I think also to understand that the cyclical nature of markets is like a very natural and repeating one. And I think that our memory is just much more like a goldfish than we'd like to admit.

And I mean, you and I were having this conversation beforehand of even if you look at how a farmer operates, right? And and you look at the seasons of summer and winter, a farmer is planting their seeds at the end of winter into summer, right? They're letting those plants grow through summer, through the boom. They're harvesting at the end of the boom, basically taking those proceeds, reinvesting through the winter, and then getting ready to do it all again. Now, a farmer knows that, you know, summer and winter are going to be this very cyclical process.

I think that markets being more synthetic can lead us to, you know, delude ourselves or you have people like the 3AC guys being like, you know, this is a super cycle, it's never going to bust again, right? And so then you can get lost in that. And that's the really tricky thing is like uh resisting the temptation to get lost and accepting that, you know, the cyclical nature of markets is inherent to markets because markets are made up of humans and humans themselves are very cyclical. Yeah, 100% the uncertainty around the timing that you have as a DeFi farmer, you don't necessarily have as a as a as a physical farmer. Totally.

Uh but the same lessons sort of apply. Well, and that's that's that's actually another great point because when I study the psychology of buying market bottoms versus, you know, like selling more towards the top, I think one thing that people really struggle with is struggle as it pertains to selling is when you're selling, your um you have like a potential a potentially infinite upside loss. Yeah. Right? Cuz you sell, let's say you're up 10x, and then it goes another 10x from there.

Like you have a very large loss. Now, no one actually knows what the asset's going to do, but the anxiety of an infinite upside loss or perceived loss means that people hold forever, right? Whereas when you're buying more near bottoms, you know how much you can potentially lose. It's however much you put in. Yeah.

And so I'd say, you know, once you develop conviction, it gets pretty easy to accumulate bottoms, but it takes a lot of work to deal with that hypothetical infinite loss when you're selling. And I think it really is just um being comfortable with where you're at and and knowing that, "Hey, this is enough. This is enough for me." Someone else might hold for longer, make more money. They might hold for too long.

They might lose all their money, but for me, this point is enough. Yeah. So, we've got just a few minutes left. I think, you know, one thing that isn't really discussed enough is this concept of private market valuations and public market valuations. We both run funds that invest both in publics and privates.

Yeah. And I'm curious how you kind of think about the relationship between those, and there's kind of like a lead-lag effect to some degree. And as you're deploying capital out of the fund or just generally your thought process, um how do you think about the difference between public and private market valuations? Yeah. It's a great question.

Um public markets always lead the private markets because public markets are marked to market every second whereas private markets are really marked to market every quarter. So once every 90 days and so what you end up seeing is you know public markets will boom private markets will chase them. And then private markets will kind of overshoot public markets. So like if you look at 2017 that was the boom year for public markets and then 2018 was actually the really big venture funding year, right? And same thing 2021 huge year for public markets but then lots of momentum from private markets into 2022 and then you know now both are are drawing down and kind of compressing together but then similarly I would say private markets will bottom a bit after public markets and so as an investor that plays in both public and private um you can kind of play the time delta a little bit where you know like early on in a bear I'll spend more time in the public markets because that corrects much more quickly while private markets are still elevated and then later stage in a bear or into an early bull you actually have some of your public market positions inflecting at the same time that private markets are still trying to get off the bottom and so then that would be the time period where you'd really want to be focusing more on private market investments.

Yeah, that makes a lot of sense. I think the other thing that happens that isn't always fully appreciated is like in the private markets these you know these companies will raise or protocols will raise and if they're in building mode and the and then you know we have a crash they just won't raise again so they sort of don't get or it's like it's more difficult to sort of like accurately mark and it's something that I think like every fund has to think a lot about in terms of like how do you actually apply valuation metrics. Well and one one amazing you know thing with in crypto is like right now, if you look at the public markets, there's tons of opportunity for venture scale returns. And that's, you know, part of the point of crypto is that you have open access to anyone with a smartphone and an internet connection to venture scale returns. And so there is the trope of like the evil VC, but like if you look at lots of VCs investments from 2021 and even 2022, a lot of those VCs are very underwater.

I mean, we have positions that we invested in where now you can accumulate that same position in the public market at 60, 70, 80% beneath Yeah, beneath what you paid in the private markets. Yep, makes sense. Well, Steve, we're almost out of time. Thanks so much. Always fascinating to chat with you.

Yep.