When I was first asked to write this column for CoinDesk, I called an old acquaintance, financial advisor and OnRamp Investing CEO Tyrone Ross, who has channeled his exuberance into proselytizing and teaching the benefits of cryptocurrency investing to financial advisors.
I wanted to pick Ross’ brain on what he thought our industry most needed to know about digital assets – and one of the first things out of his mouth was valuation.
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“As far as literacy is concerned, the biggest trip-up for advisors is still the valuation methodology for crypto assets,” Ross said. “There is no way to discount cash flows for crypto assets. You need to embrace new valuation methodologies like daily active users or network access. If you’re still talking about price-to-earnings ratios, discounted cash flows or the capital asset pricing model, you need to realize that those terms do not apply here. The old models don’t fit.”
Most advisors are well versed on valuation methodology for traditional assets like stocks, bonds and real estate, though these asset classes have their own unique characteristics and there are ongoing debates about the best way to value them and how to use that information.
For example, many professionals have abandoned the once widely practiced method of using a ratio of a stock’s current price to the book value of its business as a measure of whether it is expensive or not. Still others contend that in a world full of intellectual and virtual property, the discounted cash-flow methodologies of venerated investors like Benjamin Graham and Warren Buffett are no longer as relevant to a company’s value as they once were.
If we can understand how technology and digital breadth can make a company worth more than its tangible parts, maybe we can understand how an entirely digital asset could retain value without any of those tangible parts.
What are digital assets worth?
The fundamentals of fiat currencies are founded upon their utility as stores of value, units of measurement and mediums of exchange. Most cryptocurrencies have similar characteristics, but because much of the trading thus far has been speculative, they’re an asset class where technical analysis reigns supreme. The actual fundamentals of cryptocurrencies are still being explored by technologists and academics alike.
“In many cases, it’s the hands-on users who know more about what is going on with the technology and understand these business models and the ‘tokenomics’ of their projects more than any advisor would,” said Matthew Sigel, head of digital assets research for VanEck, a traditional asset manager that was an early entrant into the digital assets space. “That’s why I look at Reddit and see who is trading code on GitHub. These are open-source technologies, for the most part; no company is building them, so you can go read what developers are building and what participants expect as far as the economics around a token and its features.”
In my previous column, Sarson Funds Chief Marketing Officer Jahon Jamali told us that most cryptocurrencies can be valued based on the size of the network participating in their underlying blockchain.
That sounds great, but what does it mean, exactly? Goldman Sachs published a note in July confirming that the free-float market capitalization of major cryptocurrencies, including bitcoin, ethereum, bitcoin cash, litecoin and XRP, actually does correlate to the network size. We can use network size and Metcalfe’s law, a mathematical principle that the value of any network is the square of its number of participants, to figure out what these tokens are worth.
Of course, that means we have to find true and relevant methods of measuring the size of a network. Just as price-to-book and price-to-earnings ratios may not tell the whole story about the values of today’s stock market leaders, we need to find the right metrics to uncover the size of a cryptocurrency’s underlying network.
On-chain metrics give us information about the activity across a blockchain, including transaction count over a set period, or the total value of transactions over that period, active addresses, hashrates and fees paid.
Project metrics tell us the thinking behind a cryptocurrency, the technology it uses, its use cases and the supply and distribution plan for tokens. Finally, financial metrics tell us the market capitalization of the asset, its liquidity and its volume.
With some metrics in hand, it’s up to us to use them in meaningful ways to describe the value of a digital asset. One proposed method is the network value-to-transaction ratio, or NVT ratio, calculated by dividing the market-capitalization of a digital asset by the transaction value over a set period. Another method, market-value-to-real-value ratio, or MVRV, is the ratio between the market capitalization of a cryptocurrency to the value of tokens stuck or abandoned in inactive wallets. MVRV is an expression of relative value that may indicate whether a token is overvalued or undervalued.
Why it matters
“Trust officers and estate attorneys need to make decisions on digital assets, but there’s no industry standard yet,” said Whitney Solcher, chief investment officer of Ulrich Investment Consultants, a registered investment advisor (RIA) with $2 billion in assets under management. “How do you value them? How will they be taxed? How do you transfer them on to the next generations?”
There are some advisors who understand full well some of the valuation techniques behind digital assets, but are still hesitant to embrace them. Ulrich, for example, runs most of its investments in-house and follows the cryptocurrency space closely, but has decided to hold off on investing in digital assets.
“Broadly, as financial advisors, we have a hard time assessing actual cryptocurrencies as true money, and we don’t feel they are really a store of value now given their volatility,” said Solcher. “We do, however, believe in the technology, and that’s the place we’re more comfortable putting our investment dollars.”
Solcher said that Ulrich accesses the blockchain technology world through investments in companies such as PayPal, Amazon and JPMorgan Chase.
But the prevailing trend is that fewer advisors today spend their time valuing their clients’ stocks and bonds than in the past, investment management is more often than not outsourced, and thus, it’s less important that advisors know the intricacies of cryptocurrency valuation. Instead, they should be able to translate these fundamentals to their clients in a digestible way while being able to access digital assets through a variety of products and strategies.
So yes, moving forward we will need to know why a digital asset like bitcoin or ethereum has intrinsic value, but we probably won’t be called to calculate that value in real time.