Bitcoin and ethereum’s intrinsic valuations

Crypto asset valuation remains an emerging topic seeking consensus, especially as the asset class expands and matures. We propose valuation methodologies that reconcile various investors’ approaches in recent years

Bitcoin ethereum

Robert Greer, author of What is an asset class anyway?, argues assets that lack an objective measure of value and have a supply constraint are more vulnerable to irrational exuberance, citing the ‘dot-com’ bubble as an example.

Crypto assets lack an objective measure of value today among investors, similar to emerging tech companies in the late 1990s.

We can value any asset using two approaches – intrinsic or relative. Intrinsic valuation measures an asset’s value based on its capacity to generate cash flows.

On the other hand, relative valuation methods, also called “pricing”, estimate how much to pay for an asset based on what others are paying for comparable ones.

Investors might use a discounted cash flow method (DCF) to value a stock, but they would not use that for a piece of fine art.

Similarly, we must outline the various types of crypto assets to understand the differences we may expect in their value accrual and specific valuation approaches.

In this regard, it is helpful to categorise crypto assets according to the three asset superclasses proposed by Robert Greer:

  1. Capital assets: “An ongoing source of something of value” (e.g., bonds and stocks).

  2. Consumable/transformable assets: “You can consume it. You can transform it into another asset. It has economic value. But it does not yield an ongoing stream of value” (e.g., physical commodities).

  3. Store of value assets: “They cannot be consumed, nor can they generate income. Yet they do have value” (e.g., currencies and collectibles).

Like the internet architecture, cryptoassets and blockchain technology have two layers: (1) infrastructure and (2) applications.

In his 2019 work, Chris Burniske categorised crypto assets at the infrastructure layer based on the consensus mechanism of the blockchain:

  1. Proof-of-Work (PoW): In PoW networks like bitcoin, the native asset (BTC) relies on a computationally and energy-intensive lottery called mining to determine which block of transactions to settle on the blockchain and reward the miners. Hence, they belong to the consumable/transformable asset superclass, as they essentially create “a digital-native commodity in the form of secure, globally accessible ledger space”. Investors can use the mining cost of production as a fundamental metric to gauge the lower-bound price of PoW crypto assets like BTC.

  2. Proof-of-Stake (PoS): In networks like ethereum and solana, validators must commit a portion of their capital – the “stake”, in this case, ETH – to gain access to a recurring value stream generated by the network’s rules. Hence, they fall in the capital asset category, and their value may be derived from the net present value of annual flows to validators using a DCF method.

While we will not delve too deeply into the application layer, we can apply the same first-principles thinking:

  1. Governance tokens yield voting rights and represent ownership of the application. They are analogous to common stock in traditional finance, so they fall in the capital asset class.

  2. Utility tokens drive the economics of the system as their sole function, meaning they fall in the Consumable Asset category.

  3. Non-fungible tokens (NFTs) are collectibles like fine art in their most typical form today, falling in the Store of Value category.

Intrinsic valuation: Ethereum

From the standpoint of a validator, PoS assets like ETH are akin to a stock paying a dividend yield, which means we can conduct a DCF valuation following four simple steps:

1. Estimate the cash flows during the life of the crypto asset

a. Transaction fees within the network accrue to validators. Just so, fees are a proxy for revenue. Ethereum validators received $401.7m in transaction fees (net after the burn mechanism) from 28 January 2023 to 28 January.

b. Token issuance does not dilute the value of validators. On the contrary, they have the right to new issuance, similar to how shareholders may receive stock-based compensation. ETH Issuance from January 28 2023, to January 28, 2024, amounted to $1.5bn.

c. Total cash clows: a + b = ~$1.9bn in the first year.

2. Estimate expected future cash flows and the lifespan of the crypto asset

a. Future cash flows: We propose a slight variation of the three-stage growth model to project ethereum’s future cash flows. Specifically, we forecast an initial period of aggressive growth, followed by an incremental decrease that eventually stabilises at a more moderate growth rate.

b. Lifespan of the asset: With public companies that at least in theory can last forever, equity analysts generally assume that cash flows beyond a specific point in time continue in perpetuity. Investors may apply the same logic to PoS crypto assets, but for simplicity’s sake, we assume ETH’s life will be 20 years.

3. Estimate the discount rate to apply to these cash flows

a. Lower-bound discount rate (9.9%): In the past 10 years, the Invesco QQQ Trust ETF obtained a 9.90% compound annual return.

b. Higher-bound discount rate (21.9%): Obtained using the Fama and French Three-Factor Model (market premium, size premium and value premium).

4. Estimate the net present value (NPV) of cash flows using the above parameters

Assuming a discount rate of 9.09%, the implied price per one ETH today would be ~$5,315, a 134% increase from ETH’s price ($2,268) as of January 28, 2024.

On the other hand, if we use a 21.90% discount rate, the implied price per one ETH would be **$1,349**, a ~41% decrease from ETH’s price, as of 28 January.

Investors should interpret the results of this DCF valuation with caution and run their own assumptions regarding projected cash flows and discount rates.

The rationale behind our approach was to be conservative and capture the high volatility of ETH in the discount rate to accurately reflect the asset’s riskiness.

Another implicit assumption of this approach is that the asset’s monetary premium (Store of Value) is embedded into the DCF.

Chart 1 21shares March 2024

Source: https://ark-invest.com/articles/analyst-research/bitcoin-new-asset-class

Intrinsic valuation: Bitcoin

When it comes to crypto-commodities, the marginal cost of production is vital as it sets the price floor at which producers (miners) are willing to sell. From the outset, it is crucial to emphasise that we are not suggesting that the price of BTC should be determined by its marginal cost of production.

To do so would be to adopt a labour theory of value, which is ostensibly false. Instead, the marginal cost of production is a tool that can help investors estimate a lower bound price level for BTC and other crypto-commodities.

Chart 2 21shares March 2024

Source: 21Shares

In 2019, Charles Edwards proposed a methodology to estimate the global average US dollar cost of producing one BTC. The first component of the method is the Cambridge Bitcoin Electricity Consumption index (CBECI), which provides an up-to-date estimate of the bitcoin network’s daily electricity load.

Edwards estimates the cost of production per BTC by:

  1. Calculating the number of BTC mined per ray (based on miner rewards)

  2. Calculating the daily electricity cost to mine one BTC (daily electrical cost)

  3. Estimating the global average “elec-to-total cost ratio” = (bitcoin electrical cost)/(daily cost of running a bitcoin mining business).

An investor can then compute bitcoin production cost as (daily electrical cost)/ (elec-to-total cost ratio).

Finally, the bitcoin production cost is compared to the “bitcoin miner price”, which attempts to capture the revenue one BTC provides to miners.

Bitcoin miner price is calculated as follows: BTC price + (daily transaction fees)/(daily BTC mined).

When the BTC price is below the total cost of mining one BTC, it signals that bitcoin miners may be struggling and potentially taking short-term losses.

The estimated global average electricity cost to mine one bitcoin is $23,211.1, as of 28 January, while the estimated global average total cost to mine one bitcoin is $38,685.1.

To reiterate, investors should not interpret this range as the fundamental value of bitcoin, which is subjective, but rather as an estimate of its price floor based on miner profitability and subsequent behaviour patterns.

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.

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