The Next Step in Cryptoasset Valuation

In the aforementioned report we present an upgrade to the cryptoasset valuation methodology. Here we would like to share it with a wider audience. We welcome any feedback, especially substantiated critique, as we are firm that the valuation models for digital assets are yet in an early stage of development.

Cryptocurrency valuation is the key conundrum for traditional investors who have only recently begun paying attention to the new asset class. However, the valuation methods lag, as usual. Equity markets had existed for four centuries and the New York Stock Exchange operated for 130 years before Discounted Cash Flow (DCF) methodology became the mainstream in equity valuation. Unsurprisingly, with 10 years of history no one really knows how to value cryptoassets yet. Despite attempts by a few research enthusiasts, a mainstream valuation method still needs to be developed.

NVT is a ratio between a network market cap and its daily transaction volume. Network value (NV) is identical to M (size of the asset base), if we use the equation of exchange designations. In other words, NVT = M / Tdaily by definition, where T stands for aggregate on-chain transactions. Now recall that the right side of the equation of exchange, P*Q, is a blockchain transaction volume by definition also, i.e. M*V = P*Q = Tannual, with P standing for the price of a good or a service provisioned by the blockchain, and Q representing the quantity of such a resource. Therefore, M / Tannual = 1/V, where V stands for annual velocity of an asset.

Daily transaction volume, and NVT ratio as a result, are very volatile. To smoothen NVT’s volatility, Dmitry Kalichkin suggested using transaction volume’s moving averages. However, another approach to smoothen NVT would be using a trailing annual transaction volume as denominator in the ratio. We call it NVTannual. In this case, NVTannual = M / Tannual and we arrive at a very simple formula:

NVTannual = 1/V

Regardless of what kind of transaction volumes we take — daily, annual, moving or any other averages — the inverse relationship between NVT and V will stay: NVT = Const / V. Therefore, a blockchain NVT ratio is a function of just one variable — velocity of its native coins.

This brings us to some very important conclusions. Given that various coins are likely to have different velocities (e.g. due to different use cases), we cannot use NVT ratios to compare those coins. Moreover, we cannot use NVT ratios to compare the same coin in different stages of its native blockchain development since its velocities are likely to change over time. It seems that NVT is only applicable for mature blockchains with rather stable velocity for its coins. The NVT valuation method would only be used to estimate current intrinsic values of active blockchains, much like P/E ratio can only be used to value profitable entities.

We introduce the concept of the Network Value to Future Transactions (NVFT) ratio, which could be a better approach to cryptocurrency valuations. Traditional finance places more value on price to future earnings ratios than on price to historical earnings. By the same token, it makes sense to use NVFT to value cryptoassets. However, with NVFT even more unknowns appear. The cryptocurrency market has to become mature enough for the analysts that cover blockchains to estimate their future transaction volumes and to arrive at a consensus forecast. So, we will leave it as a concept for now.

Nevertheless, equipped with the NVT / Velocity equation, we can make much more reasonable judgments on NVT ratios. Although without velocity values we still do not know the fair values for the ratios, making assumptions on more tangible velocity is easier than speculating on abstract NVT ratio values. Utility tokens should have high velocity and as such their NVT should be low. If a token changes hands every day, its annual velocity equals 365 and NVT equals one.

Now, let’s focus on the main purpose of this article, absolute valuation methods. The fact that Burniske and Winton’s models in reality consider only one, arbitrarily chosen, future period bothers us the most. The model forecasts a blockchain’s CUVs (Current Utility Value) for all the years up to the one when the network matures, i.e. reaches its assumed market share. Then the model discounts the CUV only for one, arbitrarily chosen year, effectively disregarding all intermediary and subsequent CUVs and making irrelevant all the complicated calculations used to derive them. In this case, for instance, a network with initially steep adoption curve would be unfairly valued equally to a network with initially flat adoption curve if both have equal CUV in the year which we decide to choose for discounting.

This model also assumes a constant velocity for the coins, which is unlikely to be the case. However, we don’t consider this a major drawback given that the approach accounts for just one future period and only the velocity in that particular period matters. This also leads us to believe that it makes less sense to model a dynamic velocity if all of the periods except one are ignored, as in Alex Evans’ update to the initial model.

We introduce our in-house valuation approach which is our modification of the Burniske/Winton model. It considers all stages of a blockchain’s development, and assumes a dynamic velocity, thus, dealing with the above discussed issues. We would hesitate to call the number generated by this approach a “target” or “fair” price, given that the model only applies to coins with utility value and to developing blockchains. We would instead call it a Rational Network Value (RNV).

The rational utility value of a network is not just the discounted future CUV of a particular year, nor is it the sum of discounted CUVs of all projected years, we believe. We think that blockchain’s rational utility value is better modelled as today’s utility value plus discounted additional current utility values (ACUV) for every year to infinity. ACUVt in a year t equals the difference between CUVt in the year t and CUVt-₁ in the year t-1.

ACUVt = CUVt — CUVt-₁

The commonalities and differences of our approach are easier to explain with a simple example. Consider a network that matures in five years and subsequently grows with the annual rate g indefinitely. CUVt is network’s utility value for the end of year t. The additional utility value ACUVt for the period t is equal to CUVt — CUVt-₁. TV for the end of the year five equals ACUV₆ /(r-g) = ACUV₅ *(1+g)/(r-g). This is a classic formula for terminal value, where r is the discount rate.

In this example, the RNV would be as follows:

The charts below show which CUVs are considered in each of the models:

If we do the same exercise with the three approaches using INET model and the velocity growing from 20 in the year 2018 (as originally assumed in INET model) to 365 (tokens change hands daily) in year 2028, we obtain the following target prices: Burniske’s model — $0,014; Multicoin Capital model — $0.79; HASH CIB model — $0.39.

We stick to the KISS principle.

Imagine a blockchain project, called UT, which aims to provide decentralized storage service and to take 10% of the global storage market share by 2028.

Assumptions:

· Global storage market is estimated to be $30 billion in 2018 and is expected to grow between 22% to 13% from 2018 to 2028.

· UT market share grows from 0% in 2018 to 10% in 2028 according to the classical logistic function (or S-curve)

· UT coins velocity grows from 0 in 2018 to 365 in 2028 concurrently with UT market share according to the same S-curve

· UT has 50 million coins in circulation with a 5% annual inflation indefinitely.

· Discount rate is 40%

First, we derive UT market share for each period according to the logistic function. Second, we calculate UT transaction volume for every year as a product of its market share and the total storage market. This transaction volume is CUV in terms of our valuation model. Third, we calculate the ACUV for every period from 2019 to 2028 and the terminal value (TV). Forth, we derive UT coin velocity for each year. Then, we find the number of coins in circulation for each period. Six, we compute the discounted ACUV for each period and TV for 2028 and divide each of them by the corresponding number of coins as well as by velocity values. Finally, we sum up CUV for the initial 2018 year and all the values derived in the previous step to arrive at the Rational Value for UT token at the end-2018.

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