Understanding Valuation Methods

Level 1 - NGMI

Welcome Avatar! We overshot a bit with the basic overviews and realized we need to include some definitions on how to value each protocol. If someone is new to crypto they might go to a website like this (LINK) and assume that the fees go “directly to the coin”. Unfortunately, this is not true. Also. When you look at valuations Price/Sales is *not* the same as Price/Earnings. This post is going to explain how investors think about valuing protocols and you (yes you!) can decide how you would value each aspect of the coin/token.

Users Are First

Back in the early days of the Internet, companies were valued on insane metrics such as “eyeballs per day”. This was essentially valuing internet companies based on how many page views it got even if there were zero revenues being generated by the website.

That said, in crypto, the number of users is critical. You can’t have a successful project if no one uses it. Examples here: Daily Active User (DAU) -number of people who engage with an application in a day; Weekly Active User – number of people who engage with an application on a particular week.

Basic Concept: If you launch a new application/project there is no value without users. It would be like creating the “next Facebook” yet no one joins. Doesn’t matter how much you spend.

If you spend a billion dollars on marketing to hype the coin and it goes up 1,000%, you may be able to scam the masses but you won’t scam the Turbo Autists. The smart people will see if the project is being used or if it is all hype.

Intermediate Concept: When you hear about new competition, be careful about “jumping the gun”. Just because a project says it will be the next “Bitcoin Killer” because it is faster… does not mean that anyone uses it! The on-chain activity will not lie.

Advanced Concept: As you’ve seen on BTB there are times when there are liquidity trades/squeezes. This means you can look at the number of coins outstanding (free float) and calculate if the price will go up just due to a low float! This is how you can profit off of some projects that are likely going to zero without losing your shirt (per usual sell 1/2 if you ever double your money in US token terms).

Finalized Expert Concept: If you have something that is *not* making money right now, it *might* be a good investment. A great example of this would be something like WhatsApp. There are millions of users that download this product. If they wanted to, they could put a small Banner Ad on there one time every day and make millions. So. The users *do* have value even if the application is not currently making money. This is something you should consider when evaluating a project. Note: the WhatsApp example was just that, an example. It would be foolish to do something like that as the value is in the Data, not a random banner ad.

Sales vs. Profit is Second

Now that we’ve filtered out the projects that are trading based on “hype” we can now figure out if the project makes money. For those that are in the know, if you’ve ever run a business, Sales does not mean profits! This is how all of those fake Instagram flexers are able to show off their “Bank Accounts”.

Simple Example: If you sell diet pills for $100 a pop and sell 10,000 units that would be $1,000,000 US Token. $1,000,000 US token would hit your “bank account” and you could impress teenage boys and <80 IQ people with your $1,000,000 bank account balance!

The $1,000,000 is your sales number, not profits!

After that you would need to deduct the following costs: 1) cost of making the pills, 2) cost of shipping the pills, 3) cost of packaging the pills, 4) refunds, 5) all employee salaries/benefits, 6) warehousing costs and more! After all of that is out AND you pay all your *taxes* then you would be left with Earnings!

Sales: Sales is the total number of dollars you’ve collected.

Profits: Is the total number of dollars you’ve collected *after* all expenses and taxes.

For those with finance backgrounds you’re probably laughing at how easy this is. And. You’d be surprised at how *hard* it is to figure out how much money each coin/token/protocol actually earns!

Quick Valuations are Third (Ratios)

Price (Market Cap)/Sales = Total valuation of the Company/Token/Coin divided by the total Sales. If a project has a Market cap of $100M and it has sales of $10M it would be 10x

Price (Market Cap)/Earnings = Total valuation of the Company/Token/Coin divided by the total earnings. If a project as a Market cap of $100M and it has earnings of $5M it would be 20x

Basic Valuation Concept: These small metrics are all you really need to get a *high level* understanding of how much a protocol should be worth. For example: if one project is making $1M in sales and $500K in profit it should probably be worth *more* than a project making $800K in sales and $200K in profit. This makes logical sense.

The problem? There is always nuance. If you learn that the first project is seeing users decline by 20% per month while users in project two are *growing* at 30% per month… Your opinion likely changes dramatically.

Intermediate Valuation Concept: Now that you’re comparing sales, profits and user growth, you have to consider *how the project is making money*.

For example: if there was a company making $1M a year with 100 customers, that is worth a lot more than a company making $1M a year with two customers. Why? There is more risk that one of the two customers leave compared to seeing 50 customers suddenly leave overnight.

How does this apply to DeFi? You have to look at *how* the project is earning money and decide if the high earning parts will sustain long-term.

Expert Valuation Concept: The value of the earnings are also not the same. If you had to choose between inheriting $10M worth of an oil and gas stock or $10M worth of a any tech stock of your choosing, you’d probably take the tech company (unless there is some “Gotcha” exception to the rule).

Why? The Oil and Gas sector is heavily cyclical and under long-term pressure (Electric vehicles, regulations, etc.). If you could choose to invest in the Tech Industry there are likely hundreds of better options for the next 10-20 years.

This is why the “earnings multiple” would not be the same. You would pay a lot less for $1M a year earned through the Oil and Gas sector when compared to say an AI research company that is used in every government application in the world (making up an example).

If you want a clearer example: would you rather own $10M of Google or $10M of Exxon if you were paying the exact same Price/Earnings multiple?

Long-term Valuations are Fourth (DCF and More)

For the Purposes of this substack, we’re using a Discounted Cash Flow model as consistently as possible. A DCF is basically projections on how much the firm will make over the next several years. Best with yet another example!

You have a Company A: This Company is expected to make $100, then $120, Then $140 then $150 forever.

How much is the Company worth? Well it is not worth $100 + $120 + $140 + ($150 * infinity). You have to come up with a discounting mechanism.

If you have $100 today, if you invest that money you would probably have $110 or more (10% return is reasonable). Therefore… the $120 is not worth $120.

It is worth $120/(1+10%) = $109.09. This concept is highlighted in red.

At the home stretch! In the real world, it is not possible for a Company to have infinite earnings. Most companies go bust within a few years. Therefore you use a *Terminal Value*.

If you believe you can project the next 5 years of earnings with good accuracy, then you would do that (discount the returns) and be left with a terminal value calculation.

TV = terminal value; FCF = free cash flow; n = year 1 of terminal period or final year; g = perpetual growth rate of FCF; WACC = weighted average cost of capital - for purposes here just assume the WACC = your discount rate and that g is always smaller than your discount rate.

Fifth to Be Continued!

As of June 29, 2021 this is all you really need. We will make a fun public bet though. New metrics will be used to value DeFi in less than 12-24 months. This is because there are other issues in DeFi that don’t relate to stocks/bonds/traditional finance.

For example: How about levels of decentralization? Should a coin that is 100% centralized and controlled by an entity (like ripple) be valued the same? How much is enough decentralization? Should that expand or reduce the multiple after X% centralization?… Other issue, how much of the assets are rehypothecated? Do we know? Can we estimate the ratio?… And more to come!

As you can see this will be an updated post over time and will be linked to the FAQ.

Paid Stack: This post is free as it is basic knowledge that everyone needs before taking a deeper look into individual coins/protocols. We are creating living/breathing documents coin by coin to get everyone ramped up over the course of 2021. By that time we expect the substack to take a life of its own as the winners separate themselves and create more complex products. If you’re interested in DeFi we strongly suggest you sign up as you’ll get direct access to research that usually costs $6,000 a year from competitors. And. We don’t take any ICO money so there are no mis-aligned incentives (unlike with the VCs who dumped $ICP - Insane Clown Ponzi - on the public for $90B in less than a few months!)