Crypto assets are a very new and evolving landscape. With a new asset class comes new conversations, such as, how do we analyze the fundamental value of these assets, assuming there even is any?
This will be an abstract overview of our philosophy around evaluating fundamentals and Identifying value in crypto assets. The goal in approaching this new space is to cut out the noise and come up with pragmatic strategies for taking advantage of its rapid growth.
When looking for investment opportunities in crypto, or any investment for that matter, it’s crucial to keep in mind that there’s a significant difference between a useful product, technology, or asset and a good investment.
As we know with the crypto market, prices can be highly volatile. So understanding the fundamentals gives us a baseline of what price we think the asset should be trading at. Knowing that price, we can then understand when an asset is undervalued, presenting a buying opportunity, as well as when to trim our positions if the asset’s price has become overextended from its fundamentals.
This approach is an important aspect of understanding and managing the potential risk factors associated with any given investment. To highlight a prominent example of this, let’s go back to the late 1990s and early 2000s.
In the days of the dot com boom in the 90s the Nasdaq composite index – the top 100 US tech stocks – soared 2000% in just 10 years. Yes, you heard that right, 20x in 10 years. While much of this growth was legitimate and supported by the growing fundamentals of the new internet industry, the explosive growth eventually turned into what we now refer to as the dot com bubble.
This chart depicts the Nasdaq Index in orange and the earnings of the index in grey. Looking at this chart we can see in late 1998 when the price of internet stocks became wildly overextended from their actual earnings.
This is a monumental example of the difference between a great product and a good investment. While internet stocks, as a whole, might have been fantastic investments in the early to mid-1990s, the Fear of Missing Out (FOMO) quickly drove investors to buy the hottest stocks agnostic to price. As the price-to-earnings ratio of the Nasdaq soared beyond 200:1, the technology sector quickly turned into great products and innovation, but horrendous investments.
In fact, if you bought the NASDAQ index between 1999 and 2001, it would have taken over 10 years for your investment to just break even. The investors who stuck to the fundamental principle of value investing i.e. buying good assets *at attractive prices* would have been in a much better position.
Understanding the differences between price and value is crucial in knowing where you are on the investing to gambling spectrum. If a company or asset is very useful but is extraordinarily overvalued due to excessive speculation, it’s no longer a viable investment.
Now, speculating isn’t all bad, and as the chart clearly shows, you still could have made a lot of money by speculating, were you to properly time the market. However, the key is understanding where we are on the risk scale in order to make optimal decisions. As they say, if you’re going to a casino only bring money that you’re willing to lose.
The Factors In Evaluating Crypto Fundamentals
So what factors do we look for when analyzing the value of any given crypto asset?
When determining a project’s value, there are 2 key factors to consider.
1. Factor one is value creation, which is the value being created by the project, for example, metrics like how much revenue it’s generating or how many users it has.
2. The second factor is value capture, this has to do with how the project’s token captures the value that the project is creating.
One other way we can think about these factors is: one, is the project growing, and two, does the token actually benefit from that growth? For example, you could have a project that has many users, billions in capital inflows, and hundreds of millions in revenue, however, if the token’s only utility is governance and it also has a high inflation rate, it might not be worth very much.
Thus while you could make money speculating on the token, the reality is that your risk will be much higher. Aside from the outliers, such as Bitcoin, where its entire value proposition is centered around the asset, the majority of crypto projects have two aspects, the application or protocol, and the asset.
To use a business analogy, we could think of the protocol or application as the product or service, and then we can think about the token as the project’s stock or bonds. Although crypto assets often possess far more features and utilities, making them a grey area between a security and a sort of digital commodity, in terms of what asset class they fall into.
Value Creation (Protocol or Application)
Value creation, as said before, describes the value that the project provides to the marketplace and in turn how much demand it attracts. We could call this the “service” side of the project.
The first step to inspecting a project’s value creation is the actual service it provides.
A few of the questions that should be taken into account here are:
Is it an essential piece of infrastructure?
Is it a useful service?
Does it have practical application or is it just cool?
What is the size of its addressable market?
Are there technological or regulatory risks associated with it?
What are the potential vulnerabilities of the project’s code?
How susceptible is it to technical issues such as bugs or hacks..?
Does the project have a first-mover advantage?
Assessing the underlying technology and other unquantifiable aspects of the project, such as the team and competitors, is crucial to determining if the observed value is sustainable and what risks are associated with the project.
Measuring Fundamental Metrics
Value creation can be measured through a few different Key Performance Indicators (KPI). The weight that each of these fundamental metrics has on our analysis will vary between projects:
Capital inflows and total value locked (TVL) this is the amount of capital locked in the protocol.
Active users.
Fees and revenue.
These metrics demonstrate whether there is product-market fit and if the project is gaining demand. As with anything, we then want to consider how these metrics line up relative to competitors, and what the pattern of their growth is.
Value Capture (Tokenomics)
In crypto, code is law, as opposed to the legal certificates associated with owning a security. So we must understand the features and utilities coded into a crypto asset, to know whether or not it has any actual value. Many people fall into the trap of seeing a crypto project that is gaining a ton of users and revenue and then assuming that those metrics mean the token has value, unfortunately, that isn’t always the case.
With traditional assets like stocks or bonds, legal obligations and rights are clear-cut. By contrast, in the crypto realm, a project with significant total value locked, revenue, and users might still have a token that lacks real utility or an economic model to capture the created value. This is very important in analyzing the investment viability and fair value of a crypto asset, because value created by the protocol may not translate into the token being valuable.
Several value capture aspects include:
Utility: The token’s utility can increase demand. For instance, Ethereum’s network activity correlates with its token value as the ETH token is needed for transaction fees.
Governance: The asset is a DAO (decentralized autonomous organization) token, which means holders can submit proposals and vote on changes regarding the protocol.
Book Value: Many DAOs have a treasury, which is controlled by the holders of the governance token, effectively giving the crypto asset a book value.
Burn Mechanisms: Similar to stock buybacks, some projects might use a portion of their revenues to repurchase and subsequently burn tokens, reducing the supply, and thus creating an avenue through which holders can benefit from the project’s success.
Staking and Yield: Some tokens pay out a yield to holders who decide to lock up (stake) their tokens for predetermined periods. Staking adds value in two ways, one of which is through the yield paid to stakers, and two is through the decreased circulating supply as tokens get locked up.
Conclusion
Understanding and analyzing the fundamental value of crypto assets requires a sophisticated blend of traditional investment principles and new insights specific to the digital asset landscape. As we have seen, the distinction between value creation and value capture is paramount in evaluating crypto projects. It’s not just about how much a project can grow in terms of users or revenue, but also about how this growth translates to the value of its token.
The dot-com bubble serves as a stark reminder that even revolutionary technology and booming markets can lead to investment pitfalls if assets are overvalued. This historical context reinforces the importance of discerning between a great product and a good investment. In the crypto space, this means closely examining a project’s utility, governance, economic model, and market position, alongside traditional metrics like revenue and user growth.
In essence, successful crypto investing hinges on an informed, balanced approach. It requires investors to be vigilant about the nuances of digital assets, to avoid the snares of speculation, and to focus on long-term, sustainable value. As the crypto landscape continues to evolve, staying grounded in these fundamental principles will be key to identifying and capitalizing on genuine opportunities in this dynamic and burgeoning asset class.