Swing it like Buffet! Valuing the market from fundamentals

The crypto market’s value as a whole reflects how much profit investors expect. It’s impossible to say exactly how much the crypto market is worth. We’ll venture an educated guess by applying a price/earnings ratio to the biggest drivers in crypto - DeFi and NFTs.  Our result: Multiply $13B (billion) x your bullishness. A PE of 100 results in a valuation of $1,3 trillion. The market as a whole is currently valued at $1,90 trillion, about 1,5x that. But does that acutally mean the market is overvalued? For example, Amazon was famous for commanding ratios of over 1,000 times earnings in the years 2012-2014. If you believe that crypto is the future of money, then a 200x valuation is on the low end. How bullish are you? Does the crypto market behave as one entity?

Calculating from fundamentals

Warren Buffet famously said: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine. Buffet believes that there is a fundamental value to a stock, connected to key economic data. He is known for pouring over earnings reports for days considering fundamentals before arriving at a valuation. We’ll take a quicker approach to come to a ballpark figure for crypto market valuation. Comparing that with the current market value helps to set expectations.

Let’s get started

Indicator of choice will be the PE ratio, for price earnings ratio. Stock PE ratios are in the 3x - 60x range mostly, with the average somewhere around 20x. Here’s a well written explanation if you want to dive in deeper. When investors price a stock at a 10x PE it means they price the entire company as 10x their earnings in the last financial year. If investors expect a company to grow 30% year over year, the company’s revenue, and - simplified - its earnings grow 13x after 10 years. Such a stock would be valued at a PE of 80+. Let’s use PE on crypto. Crypto tokens are the product of development companies or organizations. Some of these organizations raise capital themselves. 

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Take DapperLabs: The company behind FLOW token, NBA Topshot and CryptoKitties. Dapper recently raised $300 million, valuing the company at $2,3 billion. This valuation is only tied to the token by Dapper’s FLOW holdings. This was likely treated as a cash position for the valuation. FLOW’s value, on the other hand, is governed by its use cases, like for transactions on the NBA Topshot marketplace, and staking. We expect the value of a crypto currency to reflect future profits in some way, right? So where will the profits come from?

Here’s where it gets interesting.

With stocks, gains in the stock price are not the main driver of high PE ratios. It’s the expectation of earnings growth. The stock price drives short term trading activity. “Wen moon?”, stock market edition. We’re going to apply the same principles to crypto. Hype can drive short and intense spikes. But long-term the coin price will reflect the value of the project.  Buffet’s weighing machine at work. Ethereum is a prime example. The mothership for a giant sized chunk of crypto projects. The source of De-Fi, if you wish. A quick look at ETH’s chart shows a clear connection between the launch of valuable projects and the price, exactly how it should be. We can see the 2017-2018 ICO craze, and the rise of De-Fi 2020. Momentum gained from successful project launches fueled short term trading and pushed the price to highs most investors didn’t believe in. This led to a sell-off and adjusted the price down.

Crypto earnings - Show me the money!

How can you make money with crypto, when we rule out flipping coins and where do earnings come from? The two main options are De-Fi and NFTs.

De-Fi is the number one profit source in crypto at the moment. Total value locked in De-Fi is more than $78 billion, according to The BlockWe'll conservatively estimate APY at 10%, assuming most value is locked in Stablecoin or Top 10 Pools. Those don't offer 3 digit yields. Recently lending out DAI yielded as little as 2,5%. While other farms and pools offer 200%$78B * 10% => DeFi profits are about ~ $8B/yr atm.

NFTs are another biggie:

  • Axie Infinity generated more fees than Bitcoin and Ethereum combined!
  • NBA Topshot already surpassed $600M in July '21, and on some days facilitates more than $30M in peer to peer transactions.
  • CryptoPunks set a new record for NFT prices weekly and Bored Ape Yacht Club and other top projects also have significant volume. .

The top 10 NFT marketplaces did about $1,6 billion in the last 30 days. That would mean $19 billion per year. Assuming the average sale net’s 25% profit. (A big assumption, need more data) We’d have ~$5B per year in profits from NFTs. Applying multiples similar to early days VMWare (100x earnings), we get $8B x 100 for DeFi and $5B x 100 for NFTs. Result: A $1,3 trillion market cap would be a cautiously optimistic market cap. At $1,9T we're seeing 1,5x this. Either we forgot something yuge, or higher multiples are justified, or we have to apply "Vitalik's razor". Named after his famous question that ended the 2017 mania?" Is the market really worth $1,9T?"

Assumptions and their limits

100x is an optimistic PE, but not crazy good. Amazon commanded 7,000 for a short time in 2012! And of around 1,000 for years. The rationale was: They’re building the future of e-commerce. And last year has seen Amazon make good on a lot of that promise. If the future of money is on blockchain. Then the future of all commerce, and of all monetary transactions is blockchain. Then 100x is poor. Using 1000x the crypto market would be under-valued by 7x!

On the other hand crypto faces regulatory risks that Amazon didn’t face. Some even say that Amazon's main edge is their ability to use the regulatory landscape to their advantage. Our exercise in price calculation is still helpful: Set the PE to your level of bullishness and arrive at a number. This number can inform your decision when and how much to invest. You could use a 50x PE if you’re into crypto but rather bearish, up to a 2,000x PE if you think we ain’t even started.

Why look at crypto as one market?

At over $1,9T we have reached a level of maturity, where we need to differentiate, by looking at individual projects and judging them on their unique merits. Chances are that we’ll see a breakout of the Ethereum price soon, called “The Flippening”.  

More and more individual projects will flourish and command sky-high prices, while others will perish and lose investor support. The overall capacity of the market depends on the wellbeing of the economy as a whole. In lean years investors will pull funds out to stay afloat, and the opposite when things are going well.

We looked at hundreds of crypto projects over the years. Here’s a couple of indicators for success:

  • Community engagement. The #1 indicator is a vibrant community. Especially when it’s inclusive and open minded.
  • Opinionated but humble leaders: Vitalik Buterin’s even handed, non-adversarial approach to communications is central to Ethereum’s success. As is Emin Gün Sirer’s humble approach to building Avalanche. (See our research on AVAX)
  • Developer engagement: Platforms thrive if cool stuff gets built using their features.

See Avalanche, Solana or Matic. 

  • Technical debt: If a project gets stuck in maximalism and religious adherence to the old, it suffers
  • Quality dApps: FLOW with NBA Topshot, or Aavegotchi on Aave are key drivers of adoption. Without widespread adoption a project will fail.

Action steps to improve your investment success:

  • Set your level of bullishness. Choose a PE ratio between 50x and 2000x and multiply that by $13B for a target market cap.
  • Head over to Numbrs.com and check out the research there to get informed about cool projects.
  • Join the telegram or discord chats of your favorite projects.
  • Check out the BED index. A set and forget way to get exposed to BTC, ETH and a pool of De-Fi. Governed by a DAO of course.

Conclusion
With a tidy amount of guesswork we arrived at valuation. If the crypto market is overvalued depends on your level of bullishness. Crypto can be the future of money, or not! One thing’s for certain: It’s here to stay. As a financial settlement layer, or underlying a million cool digital products, games and collectibles. Likely both.

Nothing in this article constitutes professional and/or financial advice. The content is provided exclusively for informational and/or educational purposes. Nothing is to be construed as an offer or a recommendation to buy or sell any type of asset. Seek independent professional advice in regards to financial, tax, legal and other matters.

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