1.5 Valuation approaches to digital assets

The question of how to value digital assets is one of the most complex and challenging issues. Digital assets have a relatively brief development history, and new use cases continue to crop up. Applying traditional asset classes' valuation approaches to digital assets poses a few challenges. Digital assets are not cash flow generative, and their limited performance track record makes it difficult to project their future performance. We summarize several common valuation methodologies for cryptoassets.

Figure 10. Common valuation methodologies of digital assets

Methodology Thesis Pros

Total addressable market

Equation of exchange

Valuing cryptoassets as a network

Cost of production valuation It estimates and compares the addressable markets with the current market capitalization Intuitive and straightforward – It provides a solid framework for order-ofmagnitude comparisons between cryptoassets and the markets they address.

The equation is borrowed from traditional models of valuing currencies. It is assumed that a currency’s value is related to the size of the market it supports and its velocity.

This approach is borrowed from technology. It states that the value of a network is proportional to the square of the number of participants. Feasibility – Numbers can be forecasted into the future for a mature market and then discounted into present value.

Intuitive – Given that daily active user is a proxy for adopting a cryptocurrency.

This approach views bitcoin as a commodity. The cost of producing each marginal bitcoin should align with the price of that bitcoin, according to traditional microeconomic theory. Data supportive – It is supported by empirical backtesting, which shows a relatively strong relationship between bitcoin’s price and the marginal cost of production

Cons

Not applicable beyond bitcoin and other storeof-value use cases

Small changes in this estimate can lead to significant changes in proposed valuations.

It requires estimating the velocity, which is problematic.

There are limitations: - appropriate only for relative valuations between cryptoassets. - gives equal weight to each user, which is not an accurate assumption

Little predictive power;

It fails to explain the short-term volatility of bitcoin price

Remarks

Most popular valuation approach

MV = PQ M: Total money supply V: Average velocity with which a unit of money is spent P: Price of goods and services Q: Quantity of goods and services

An essential part is that the value of the network is not linearly related to the number of users. Instead, it is related by a square function.

Uncertain predictive value - The causal relationship between the cost of production and price is not clear.

Stock-to-flow model It measures the scarcity, which is reflected by the bitcoin price. The ratio measures the relationship between bitcoin and the amount of new bitcoin being produced. Intuitive – the price of bitcoin has close historical correlations with increasing scarcity expressed by the stockto-flow model.

Source: Bitcoin Market Journal, CFA Cryptoassets report

Not applicable beyond bitcoin. The model only appeals to those who see scarcity as the dominating characteristic. Some are sceptical of this approach, such as academic researchers.