How to Value the Blockchain

Investing in Blockchains.

Investing in crypto is not different from any other. The challenge comes from deciding on the endgame. Don't speculate without an investment thesis. This section will breakdown how to build a crypto thesis and minimize investment risks.  

What's my investment framework?

My Investment Research Process

Remember, this is an introductory course on how to value blockchains. These are complicated assets that cannot be viewed in the same form as traditional assets. They are intangible yet transparent. The transparency helps make clearer decisions. Always do your own research. None of this is investment advice.

How do I find investment ideas?

Like any other idea, it comes down to research. There are no shortcuts here. Remember, crypto is native to the internet. It was not found in the ground or traded under a tree. So to find the best ideas you must begin with the internet. Start with Reddit, Twitter and Discord. These online communities are where ideas are sourced and made.

What does the price tell me?

Buffett famously said that price is his due diligence. Crypto is no different. With an active liquid, investors can identify when and where money is moving. The plus  is the market is always open. The negative is the market is always open. The price tells you the market value.

How do you do your research?

At the end I'll give you a few resources to read and review. They will improve your research process. Look, there are speculators and investors. Long-term investments require a deeper understanding of the fundamentals. Similar to what is offered in this course. My research process consists of qualitative and quantitative notes. What does that mean? Well I talk with investors, developers, read papers and do simple model. If the idea make sense, I make an investment. If not, I skip and move on.

How can I learn more about the team and projects?

I recommend viewing the project websites to learn about the Teams, Investors, Developers, Partners and Customers.

What is a whitepaper?

In crypto, a whitepaper is an in-depth report explaining the technical details of a project. It is not light reading. Most papers breakdown the unique characteristics of a token. This is where you can the technical information and the purpose of the project.

How can I view the security of a token?

There are two security questions you need to be aware of. Who owns the assets and what are the loopholes? This can be a technical question. Cold storage and self-custody wallets will give you control of your crypto assets. Exchanges, bridges and hot wallets are vulnerable to hacks.

For specific tokens, you will need a deeper understanding of decentralization, nodes and coding. Security strength is determined by a number of variables.

Where can I find the supply limit?

The supply limits can be on any crypto pricing website like Coinbase or CoinMarketCap. Depending on what you invest in, the supply limits can change. Very few assets have a limited supply like Bitcoin.

Where can I learn about crypto regulatory concerns?

Every country has its own set of Accounting and Regulatory concerns regarding crypto and investing. We recommend speaking to a professional for specific regulatory questions.

What Would Make You MUCH MORE and LESS positive on the Crypto?

What are the best social networks to find information?

Reddit, Twitter & Discord groups

How can I think long-term in crypto?

Think in terms of use case. Crypto is software. First, ask yourself if the software can be used? Does it have utility? Once you have achieved the bare minimum then you can understand the long-term value.

To be confident you need to put in the work. Don't skip out on a few hours of due diligence when money is on the line. This goes for crypto or any investment for that matter.

My Investment Template

When investing, I use a simple template. It begins with a summary, quantitative and qualitative analysis, an understanding of the risks and clear catalyst.

  • The Summary provides a Background describing the investment opportunity.
  • The Qualitative analysis breaks down the Business, Product and Industry. For example I'll ask myself, What problems do blockchain/cryptocurrencies solve? Why do they exist?
  • The Quantitative analysis breaks down the Financials, Valuation and expected Returns.
  • Risks cover Business, Product and Industry threats.
  • The Catalyst defines 1-2 elements that impact my investment. This may include the market, a specific event or Insider transactions.

The Ethereum Valuation Model

In this example, we'll breakdown the valuation model for Ethereum. This not investment advice. It is a demonstration to show how the economics of one cryptocurrency. Every token has its own economic model. The economics are constantly changing overtime.

As explained earlier, Ethereum is an operating system. It complements most cryptocurrencies in the ecosystem. Today we can value the user activity on-chain. Today Ethereum is an income producing asset and can be valued based on cash flows.  

Valuation Model Summary

Today, Ethereum like Bitcoin, has become a store of value. Its value is based on scarcity and security. The Ethereum network has been upgrading the system for the past several years to accomplish two things: 1) reduce transaction fees and 2) to become more energy efficient.

If you are familiar with Ethereum then you know its currency, Ether ($ETH), has been used for DeFi and NFT applications.

In simple terms, a blockchain is a decentralized database that sells storage space. It's a business that sells services. We can compare valuations of business using Price to Sales (P/S) or Price to Earnings (P/E) ratios. Let's do it for blockchains.

My thesis: Ethereum, as the most decentralized blockchain, is the best positioned for the massive scalability enabled by roll-up technology. This is when end users pay low transaction fees on L2s while Ethereum mainnet remains expensive but secure settlement layer.

Since the EIP-1559 upgrade in 2021, ETH owners have profited from the reduction in total ETH supply. Let me explain.  

"If we assume that in 20 years $ETH supply will drop to 100M from current 118M (at current projected annual supply decline of -2.5%, it would drop to 71M!), above prices would go to $12.5k (not staked) and $15k (staked)." You can review the total burn on ultrasound.money

Just the fee burn "buyback" impact is significant as it's value all accrues to the token

After transition to Proof-of-Stake model (PoS), ETH stakers will get the unburned part of the transaction fees that now goes to miners. This will be a direct profit distribution from the Ethereum network to ETH stakers. A form of a dividend.

The only cost for the Ethereum network is security. It's paid as ETH issuance (block rewards) to block producers, currently miners but in PoS - ETH stakers. There are no other costs for the network. Hardware, electricity etc. are covered by 3rd party providers.

So we have two types of cashflows: indirect (fees burn) and direct (fees + block rewards to stakers). Based on them and an expected growth rate of the Ethereum revenue, it's possible to build a DCF model to assess a fair value of [$ETH]

After Bitcoin, Ethereum is the most secure and decentralized network. This can be verified by the number of validator nodes in the system. They incentivized to ensure accuracy and secure the blockchain.

A breakdown of ETH cash flows

What is most unique about Ethereum is the level of revenue the network generates.

What are the projected ETH earnings? $14.2B. projected for 2022.

Ethereum is a decentralized blockchain network with no costs.

All costs are paid for by a decentralized network of validators.

Thus all revenues are profits for the sake of a DCF model.

You can view the crypto fees to understand how profitable other networks are.

Ryan Allis created a cash flow showing how ETH will reach $10,000 based on a 25% growth rate and 35x P/E ratio. Remember every financial model is only as good as its assumptions [issuance is structural supply, fees are structural demand].

Discounted cash flows don't apply to crypto

Maybe not in the traditional sense but the network model has changed. Up until last year, the network didn't have revenue in the traditional sense. Now we can track and own the cash flows from the underlying network activity.

What variables do I need to be aware of?

  • 1) What if majority of txns move to L2s?
  • 2) What if another L1 chain (eg. solana) wins?

Catalysts

More institutional investors buy ETH. Why? they will understand the power of a distributed computing network.

The next major buy-in will be when ETH transitions completely to Proof-of-Stake. Than stakers with 32 ETH will see real cash flows when owning this specific asset.

Institutions may view Staked Ether as Equity

L2’s will drive higher demand

Low gas fees will drive more total demand for ETH blockspace

L2s being cheap creates an incentive to use blockchains differently

What questions do I need to ask myself?

  • What are Ethereum’s current annualized cash flows?
  • What % of these are going to holders when ETH 2.0 launches in December 2021?
  • How much do you expect the annualized cash flows to grow in the future?

View past ETH quarterly reports below

For additional resources, I recommend reading the Messari 2022 crypto thesis. Their research team has done a terrific job breaking down the future opportunities in the industry. It's 200 pages so I recommend devoting an entire weekend to this report.

If you want to do your analysis, I recommend reading the fundamentals of Axie Infinity. This study gives you a breakdown of the gaming community and its Play-to-Earn model.

To invest in blockchains, you must first master the fundamentals of the network. This will require understanding key concepts and use cases of specific blockchain. Remember decentralized/distributed ledgers are built on trust. If you can't trust the network, then don't invest.