Value Investing in Crypto

A survey of the token value landscape

Reid Roman

Disclaimer: Crypto is risky – DYOR. Even if you follow our advice or invest with our products, you could lose your investment and fees. [Full disclaimer]

“There seems to be some perverse human characteristic that likes to make easy things difficult.” – Warren Buffett

The vogue with this recent crypto market correction has been vocal denouncement by the likes of Buffett and Gates, tarring the crypto sector as “greater fools” investing in inert assets with no intrinsic value. The volatility and associated risk is undeniable, and as yet there is no industry-standard crypto valuation model (akin to a DCF for public equities), in part because the biggest names – BTC and ETH – promise no cash flows, as Buffett has correctly noted in his critique. But the industry is wide and getting wider, and many tokens, ETH included, do hold substantial value beyond just novelty and artificial scarcity. In this post I’ll introduce the abstract types of token value, for aspiring value investors in crypto, and point toward tangible methods for deriving token value.

Value Overview

How much is a token worth? It’s easy to say “It’s worth what people will pay.” It’s also easy to look at the wild market swings and conclude all crypto price inflation is hype.

Much crypto capital is invested absent a strong fundamental understanding of what confers value on a token, and liquidity is not apportioned in tokens according to the value they provide. Rather than aping into shitcoins, the savvy investor will avoid tokens with unpredictable or unclear value, and instead identify tokens with tokenomics they can understand and forecast.

Types of token value:

  • Collectible value - Why is it unique?
  • Economic value - What rights does it offer?
  • Functional value - What can it do?

Value is transient or permanent – whether an engineered pump-and-dump scheme or an overhyped drop, many tokens’ value dies shortly after it arrives. Value can also be purely psychosocial in that it confers status, achievement, or association. And whether functional, collectible, or economic, much of current crypto value is insular – digital ownership of particular digital assets, access privileges to particular digital spaces, payments of one cryptocurrency to receive in another – it’s true that to value certain crypto tokens, you must first value crypto. Even so, a growing subset of tokens are delivering real value outside of the sector, expanding the overlap with other goods and industries.

What’s a Protocol

Quick definition: A protocol is a crypto application, which generally defines roles, rules for participation, and a set of functions it can perform. It may or may not not have a consumer-facing app. Chains themselves like Ethereum and Bitcoin are protocols, with roles of miners and account-holders and functions like mining blocks and transferring coin. Uniswap is a protocol that runs on top of Ethereum. If it’s simpler to substitute “app” for “protocol” in the content below, feel free!

Value Heuristics (not direct measures)

The Lindy Effect is a useful heuristic in valuing crypto assets. There is every financial incentive to hack prominent protocols, and protocols with vulnerabilities do get hacked, so tokens or protocols with volume and staying power are likely to be winners.

Market cap, volume, supply, vanity metrics – these may indicate current popularity of a chain, but they are mostly lagging rather than leading indicators. However, they are indicators of network effects and momentum. Crypto as a medium of exchange relies on a critical mass of potential exchange partners, so value begets value. Generally, the more active holders of a token, the more valuable each incremental holder will find the token.

Hype Value and FUD

When people say “value investing” they generally mean buy-and-hold, long-term investing based on a sustainable revenue model or cash flow – usually investing into a product or service that owns its niche and figures substantively into the lives of its customers. Hype value fleeting – it’s social and emotional, not functional.

Crypto traders profit off of hype –botters that scoop up NFTs at a fixed price at their drop can immediately resell them on a secondary market for profit.

Creators spend real effort and marketing dollars cultivating hype. Whether for status signaling, personal gratification, or group participation, hype is a measure of psychological value without physical value. But hype is ephemeral, and as the hype engine (marketing, community chatter, events, etc.) breaks down so will its price support.

FUD – Fear, uncertainty, and doubt. This recent market retraction has garnered a lot of FUD, amplified by the media, with the many margin calls and private bailouts. Crypto’s value is largely determined by network effects, so its volatility is amplified relative to traditional assets. Vicious cycle: bearish sentiment → retraction → presumption of compounded value loss from lost network effects → more bearish sentiment. Some of this amplification is rational. FUD, however, is negative hype – market contractions can be just as ephemeral and sentiment-driven as expansions. It’s easy to forget the billions of dollars in daily Chainlink volume (~$400m at time of writing) when the Wormhole hack or Celsius meltdown is plastered on every outlet. Disentangling FUD from irrecoverable value loss is the work of the discerning trader.

Hype and FUD are predictable with the right signals (blog post upcoming), but my soundest advice to value investors is to treat hype in profile-pic NFTs and similar tokens as the bubble it’s proving to be, and to find other investments that will hold value in the long term.

Collectible Value

Collectible value, like hype value, is derived from sentiment beyond function. Art NFTs are in their own class – the quality of the art is subjective, the ownership of the digital asset is questionable, and the resale prices are frequently manipulated. Even when not manipulated, the small supply leaves them vulnerable to huge price swings. But collectible value is distinct from hype value in that it’s sustainable, as with Veblen goods (designer handbags, e.g.).

Digital collectibles bear direct resemblance to the fine art market, and as such are subject to greater fool theory and collusion, where investors buy high and sell higher, safely presuming that outsiders will bid up the price based on trust of insiders.

The psychosocial bit, or three dimensions of sociability that factor into collectible value:

  • As social animals we find value in group membership (association), as with the Bored Apes or other NFT projects.
  • Some GameFi tokens are awarded for game accomplishments (achievement), rank, or level.
  • Other tokens are purchased or traded to indicate personality (status), role, or customization.

While there is an investment game to be played here – the Bored Apes, for instance, are still double their mint value – the price determinants will vary by collection and collectible, so unless you acquaint yourself with the idiosyncrasies, you’ll be unable to forecast the price performance of the collectible.

Economic and Governance Value

Some tokens entail ownership (like equity), obligation (like debt), or voting rights (governance) – we’ll call these security tokens (as in Securities and Exchange Commission).

DAO tokens are usually ownership and governance tokens – holders are enfranchised and entitled to proportional stake in any assets held in the DAO treasury. In such cases, past performance is an indicator of future performance, and current intrinsic value is directly calculable (portfolio value divided by tokens outstanding). A DAO may have a published investment thesis that may further inform your investment decision.

Debt valuation models still apply for tokens with obligations: The token value should equal the time-discounted amount owed.

Voting and governance rights – whether of protocols, DAOs, etc – don’t have a conclusive value. As one tradfi data point, note that GOOG and GOOGL, although differentiated by voting rights, often trade at the same value. On the contrary, MKR, whose sole value is in governance of the MakerDAO, currently trades around $1k. Many tokens that confer governance ability will also, like traditional equities, pay dividends from a community-owned treasury. For these tokens, stock valuation methods are applicable: value is presumed to equal the sum of time-discounted future cash flows.

Notably, security tokens representing claim to some underlying asset can only be valued relative to that asset, and therefore may derive their value from either collectible or functional token value.

Functional Value

Where it’s identifiable, functional value is the most stable and predictable investment. Some diagnostic questions: Can I do something I already wanted to do? Can I do it better (faster, cheaper, more securely, more privately)? The blockchain has already proven its performance for certain ubiquitous human interests: tracking ownership, exchange, investing, and socializing.

DeFi (decentralized finance) is making inroads at replacing traditional financial infrastructure. Big innovations have been made in lending (mortgages, personal loans, margin loans), remittance (cross-border transfers, wire transfer replacements), and derivatives (futures, synthetics, and market making).

Conceptions like programmable money, instant service onboarding, and commoditized cloud computing clearly stack the deck favorably toward web3 over web2, and protocols giving life to these new ideas will reliably hold value. Some names moving in this direction are Filecoin, Akash, and Helium. They have clear web2 comps, their tokens have immutable value within their protocol, and they have established networks already serving users. Akash, a decentralized compute network, offers compute resources at roughly half the cost of Google or Amazon. They publish data on active leases and daily spend from which you can project growth and future protocol earnings.

Where you the value investor can find such opportunities, these are the tokens to buy – the ones with inherent protocol utility, whose value is bound to a service with solid fundamentals and market share. Advice to “buy the dip” is overly vague and not actionable, but many projects can be bought into at levels below their fundamental value. In negative hype cycles it’s easy for the price to dip below clear support levels indicated by the user base, activity, and project fundamentals.

In Summary

What’s the point? Crypto is risky, but the savvy investor shouldn’t be paralyzed by this risk into inaction. Differentiating tokens by their value type will enable you to understand how the price of a token will change according to value inputs. This advice alone may not make you a crypto billionaire, but it should help disentangle some confusion amid wild market moves, distinguish protocols and tokens on the basis of sustainable price support, and reduce some of your own FUD as a crypto investor.

Make bets on token function. Tokens with real functionality delivered into extant industries will be more resilient than memecoins, so long as their functions are preserved during fluctuations.

Until the innovation consolidates (protocols die, merge, or dominate), we’ll continue to experience thrash and bubble behavior, but as with other tech-driven bubbles, a substantial proportion of industry value will persist after the bubble pops.

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