Back to Basics: Market Cap and FDV
Level 3 - DeFi Virgin Analyst
Welcome Avatar! Today we go over some basics around market valuation to help you better understand some of the numbers you see on various exchanges and websites like CoinGecko. We’ll then give you some insight into how we’re thinking about these metrics in the current state of the market and how you can protect yourself by avoiding tokens with unfavorable setups.
The key is a better understanding of Market Cap and Fully Diluted Valuation.
What is Market Cap and Why Does It Matter?
Market cap is the current value of publicly traded protocol tokens which are currently circulating.
Market Cap = Circulating Supply x Token Price
Another way to think about market cap is the market value resulting from the price of the last transacted trade. As you can imagine, market cap is constantly changing as trades are completed (Token Price constantly changing).
Market cap is an expression of the market’s view on what a token is worth. Think of it as the perceived value of the token and not the intrinsic or the actual value of a token.
If you’ll notice, price is only one side of the equation. Price does not reflect the market value of the entire “enterprise,” only the price of a single token. Price without knowing supply is not particularly relevant (unless a certain number of tokens gets you access to something, e.g. 100 Owl tokens gets you access to unlimited Owl feet pics).
Diversion of Market and Intrinsic Value
A token, or any asset really, can have perceived value for different reasons. A value investooor may look to purchase assets with high cash flows with low perceived value. A trader might look to purchase assets that capture the market’s attention around a news event that would increase its perceived value. A meme buyer might purchase an asset because it’s fun. There are all kinds of market participants looking to buy or sell for any number of reasons.
Market cap simply expresses the view of the market on the value of a publicly traded asset at a point in time. In an efficient market, all information is factored into the price of an asset. In theory, all assets are priced based on their future cash flow potential. Of course, you can’t apply this theory to tokens in many cases because this approach is used for equity valuation. Also, valuation is only useful to the extent the market thinks of it the same way. Chainlink’s LINK token is not an equity-like instrument but rather a utility token within the network. On the other hand, SUSHI is very much like equity in the SUSHI protocol, with profit share (dividends) and governance (voting rights).
In Defi, market cap isn’t the full story because most protocols haven’t issued their full supply of tokens yet. To conduct an accurate analysis (or simply to avoid getting dumped on), you need to understand Fully Diluted Valuation (“FDV”).
What is FDV?
FDV is the market cap of the token if all possible supply that could exist, was available today. If you’ve been yield farming, you already know that tokens have issuance schedules where new tokens are introduced to the supply over time.
Here’s an adjusted formula we use for FDV:
FDV = Token Price x (Max Supply - [Burned Tokens])
An important note here: CoinGecko’s FDV calculation does not account for burned tokens (tokens removed permanently from supply) which is why we’ve left it as optional in the equation above. We believe including burned tokens in your max supply calculation overstates FDV and that burned tokens should be subtracted for a more accurate assessment of FDV.
Note that not all protocols will have a fixed maximum supply so you cannot calculate FDV for those protocols (although you can try to project their emission schedule into the future).
When you’re investing, you’re (hopefully) looking for assets you believe are not fairly priced. One way to determine pricing is relative valuation - how is something priced relative to its peer group? Using market cap can help provide an indication of how things are valued on a relative basis. This allows you to project realistic scenarios of the upside case and the downside case in these investment examples:
Research alpha: you are well informed about your industry and so detect the fundamental value of a product or technology earlier or more accurately than the market. What range would the market cap be in your upside case? (e.g. comparing the market cap of Bitcoin to gold)
News dissemination: you’re among the first to spot a piece of market-moving news on a protocol you’ve been studying. This could be a merger, treasury buyback, hack, or announcement from a meatspace corporation. In DeFi you have could spot news with Twitter and Discord apps and also by participating in governance discussions.
Human behavior: some people understand marketing and group decision making well enough to bet on which sectors or trends will be hot. Knowledge of market cap helps inform when the investment may no longer have enough growth potential to justify the risk. For example, for rebase tokens you could calculate the rate of new investment required to sustain returns to investors based on the current FDV. When Olympus DAO hit a FDV of $3-4 billion you might think the risk:reward no longer favored holding for the majority of market participants, and so you react in advance.
Calming the panic: investors as a group are irrational with a herd mentality and will make decisions based on emotion. After periods of price decline investors become irrational, lose hope, and are often willing to sell assets far below fundamental values. In markets where leverage levels are high, forced liquidations can temporarily depress prices well below fair value.
Why does this matter?
If you invest in a token which is already valued near the ‘best case’ scenario of your investment thesis you are unlikely to make much money even if your view is proven correct.
OG readers of DeFi Education or BowTiedBull will be familiar with our DeFi Comps Table
We track FDV as part of our process of asking whether token valuation is reasonable in the context of comparisons with other protocols in the sector, cash flows, Total Value Locked, and growth. We also track the percentage of supply which has already been issued. Low percentage of circulating supply implies that there is a lot of future dilution from new issuance which could depress price.
In simple terms: low circulating supply relative to max supply means there will be more supply that will become available and will have to be absorbed by buyers (and LPs).
Let’s go through an example with DeFi Kingdoms (JEWEL).
19% of tokens have been issued, price is $16.31 and the FDV is $8.1 billion.
Our research on JEWEL was published here on December 3 when price was $8.03, which is a FDV of $4 billion.
How does this compare to the most popular video games of all time?
Mojang Studios was acquired by Microsoft for $2.5 billion in 2014. Using our knowledge of Market Cap and FDV we can see that JEWEL is valued at nearly 3x the highest grossing video game of all time, Minecraft.
Using comparisons, we see that two huge gaming companies (EA and parent co. of Rockstar Games) trade at a multiple of 5.95x on average, so to support a $8 billion valuation in gaming suggests the ability to make $1.3b per year in revenue. Of course, high growth “companies” like DFK would trade at a far higher multiple and might be more appropriately valued based on users instead of revenue. DeFi games also don’t suffer from the same level of overhead as traditional games.
That said, JEWEL operates with an unlocking mechanic whereby only a small portion of the JEWEL you earn can be unlocked (under 10%) and the rest is locked until Q3 2022. This unlock schedule is in place to reward early LPs without creating significant dumping. For people who wish to sell their locked tokens, they have a market. You can see these locked tokens selling for huge discounts, as shared in this twitter post:
Meanwhile, JEWEL is trading for ~$15 on DEXs. This trade could be value accretive for the seller if 1) JEWEL unlocks at a lower price than what they sold at or 2) immediate liquidity would yield them a trade greater than what they expect JEWEL unlock at (e.g. If I can sell my locked JEWEL for $8 and expect it to be worth $10 at unlock time, I might be better off selling it for $8 and looking for a trade that can return over 25%).
This post is not about JEWEL. The key takeaway here is that FDV does not tell you the full story. Without an understanding of when and how supply is brought onto the market and how it would get absorbed, FDV will not give you a good decision making metric. Instead, use high FDVs as a signal to dig in deeper and see if there is something other people have overlooked (either good or bad).
Rekt Police: Low Float high FDV VC-nomics.
One of the worst examples of high FDV VC-nomics is Project Serum (SRM), a DEX on the Solana blockchain (SOL). SRM has a max supply of 10.1 billion tokens and this time last year was trading at around $1.90 - a FDV of $19.2 billion. Around the same time, Solana was trading at ~$3 with a total supply today of around 500 million tokens. If the supply was 500 million last January, the FDV at $3 would be $1.5 billion.
Think about that: Solana’s market capitalization was $1.5 billion yet Serum, a DEX on Solana that facilitates trading of tokens on Solana had an FDV of $19 billion. Of course, that makes no sense.
Not only does it not make sense for an isolated DEX on an L1 to be worth multiples of the L1 token, Serum is just one app. If having a DEX on SOL was successful competition would enter so SRM could never capture 100% of the market. Should Uniswap be worth more than all of Ethereum? Should a new exchange with very low volumes be worth 4x Uniswap?
It gets better. Briefly, during May (and inexplicably again during September 2021), Sereum DEX had a FDV of…..
$100 billion. For comparison, the CME Group exchanges which process over $1 quadrillion dollars of trading volume per year has a market cap of $80 billion. Should Serum DEX be worth 1.25x the CME? We don’t think so.
Investors who thought so have lost their shirts as prices are down 78%.
Who benefits?
The investors who paid $20 million for 4% of the total Serum supply. Assuming they unloaded at a mere $20 billion FDV, they made 40x. The token unlocks range from 1 to 7 years, per the pre-launch documents.
Founders and early investors looking to make quick money have an incentive to design the token issuance and tokenomics to benefit themselves at the expense of later market participants who will ‘ape in’ without regard to valuation. Incentives ensure this trend continues until investors are educated and make decisions taking things like FDV into account.
Until then, we have been operating cautiously but not completely discounting higher FDV projects. For example, if a project has a high FDV but most of the supply is locked for the next 12-24 months, we might still invest in the project *but* be prepared to get out by a specific date. In these scenarios, you’re looking to earn yield and capture near term catalysts / change in growth expectations.
Here are the FDVs of some other Solana based projects:
We include the current FDV as some of these projects still look extremely overvalued even after losing 90% in less than 1 year for investors unfortunate enough to buy the top. The $5 billion ‘prime brokerage’ still doesn’t have a working app if Google Play reviewers are to be believed. The $2 billion maps app doesn’t look well priced relative to satnav leader TomTom NV (TOM2) which has a market cap of $1.38 billion. BonaFida has a FDV similar to PancakeSwap, the phenomenally successful Binance Smart Chain DEX which boasts tens of millions of active users and $135m/year revenues.
Emission and Unlock Schedules
Some protocols don’t have a capped supply, and for those that do, FDV doesn’t always tell the whole story. Some protocols emit native tokens in proportion to protocol usage (e.g. Convex, Curve) so emissions can’t always be predicted in advance. Other protocols will burn unused tokens, meaning the FDV is never fully realized (e.g. SPELL and ICE).
A low circulating supply can be designed to engineer a pump, as market buying only a small portion of FDV can cause the price to rise, attracting speculators and providing a market for insiders to unload on. If you spot a low market cap high FDV coin early enough, it may be a good shorter term investment.
While early investors may own a large share of the FDV, these tokens sometimes vest over several years. Don’t forget to check for looming unlocks, as the expectation of selling can depress price. 2021 may be been an anomaly for ‘bullish unlocks’.
The Token Economics section of each protocol’s Profile on Messari is a good source for unlock schedules.
Autist note: we are aware of SAFTs, OTC deals, and other mechanisms used to circumvent lock ups and vesting periods.
Concluding Thoughts
We’ll close out by emphasizing that 2022 is an especially important year for understanding FDV and how it impacts the tokens you hold. In 2021, we saw some interesting takes on Twitter from influenzas, including the famous “FDV is a meme.”
Is it a meme, or is the real meme that people want to unload they’re vastly overvalued tokens on the unaware?
Be careful out there anon. As always, we’re with you. Next time someone tries to shill you their overvalued bags on Twitter, you can go ahead and leave this image in their comments with no explanation:
Until next time.
Sources
Present value of historical deals according to CPI inflation calculator at https://www.officialdata.org/us/inflation/2014?amount=2.50
Revenue and market cap data from public companies from various public sources, mostly official filings accessed via a terminal.
Market Cap and FDV data: CoinGecko API
Disclaimer: None of this is to be deemed legal or financial advice of any kind and the information is provided by a group of anonymous cartoon animals with backgrounds in Wall Street and Software.
Would love to have a link or feature for paid subs to access a weekly refresh of the comp table. Nice work.
Stellar post. Would be nice to see more of these explaining the others valuations metrics.