The guide, “Valuation of Cryptoassets: A Guide for Investment Professionals,” was developed by the CFA Institute Research and Policy Center and “seeks to equip investment professionals with the most relevant valuation models and tools to support analysis of crypto assets,” according to the CFA.
“The issue of valuation has become a critical topic given the growth in crypto assets over the past decade, currently estimated to exceed $1 trillion in market capitalization. At the same time, the crypto assets market has undergone significant upheaval and price volatility, making an analysis of valuation drivers imperative for any investor or investment professional investing, or considering an investment in crypto assets,” according to the CFA.
“The valuation models in the guide include fundamental valuation approaches such as discounted cash flow [DCF] analysis and relative valuation approaches adapted from traditional finance, where appropriate, as well as newer models specific to crypto assets,” the CFA says.
The CFA devised the models after “interviews with industry professionals and a review of current literature. Given the plethora of valuation approaches available, many of which lack testing or rigor, only those models currently in use or considered relevant among practitioners are included in the guide,” according to the CFA.
Many current valuation models are limited and “require further development; thus, a single model or metric should not be used in isolation to value any given crypto asset,” according to the report.
Despite the limitations, valuation models offer insights into crypto asset functions and mechanics.
“Disagreement on existing models should be welcomed and embraced. Such counter analysis and critique can lead to the development of improved valuation approaches, and the introduction of new concepts and more robust datasets will improve our understanding and modeling capabilities over time,” the report notes.
Some of the major takeaways from the report include help with the valuation of “smart contract platforms, such as Ethereum," which can be treated "either as a network or as a cash flow asset,” according to the report.
“When considering smart contract platforms to be a network, a qualitative framework based on on-chain data can be used to assess these platforms on a relative valuation basis. Metcalfe’s law, which values a network based on the square of its number of users, can be continually used to value the network relative to its market capitalization,” according to the report.
For smart contract platforms to be considered as cash flow assets involves the DCF model, which “considers the transaction fees collected by these platforms as cash flows, allowing for the implementation of the model based on assumptions regarding applicable growth rates and discount rates,” according to the report.
The report defines decentralized applications as “applications with their own native tokens” for a service or product to blockchain users. “These applications can run on top of general-purpose smart contract platforms or run on their own application-specific blockchain.”
In particular, the report focuses on decentralized finance (DeFi), “a sector of decentralized applications that focuses on financial products and services. The DeFi ecosystem includes a broad range of financial products that are designed to be open source, decentralized, and noncustodial and can facilitate peer-to-peer transactions,” according to the report.
Valuations for decentralized applications “can be performed using either a relative valuation approach or an intrinsic value approach using the DCF model,” according to the report. “Such metrics as the price-to-sales, price-to-fees, and market capitalization to net assets ratios can be used to relatively value decentralized applications within the same sector or to compare them with their traditional finance counterparts.”
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“Basing each model on just one of bitcoin’s fundamentals leads to certain limitations; there is no single model that encompasses all the characteristics of bitcoin,” according to the report. “These models do provide a theoretical understanding of the underlying dynamics of the cryptocurrency and can form part of a fuller analysis of crypto assets.”
Despite all the hype, crypto assets are still emerging “and as such, there is a lack of historical data to build a comprehensive modeling framework or backtest the robustness of a given model. With regard to intrinsic valuation analyses adapted from traditional finance … and applied to decentralized applications or smart contract platforms, the lack of historical data, DCF models’ potential sensitivity to their assumptions, and rapid developments in cryptoassets pose further challenges in deciding on a proper range of assumptions to use in DCF valuations,” according to the report.
“Further, crypto asset-specific models, such as the models presented for bitcoin, present several caveats, including potential misinterpretation of variables and focusing on certain characteristics to construct the models, thus limiting their use in providing a theoretical understanding of the underlying dynamics of the crypto asset,” according to the report.
Yet the models “offer insights into the functionality and mechanics of the respective assets. An approach that uses these models as part of a thorough research and analysis process, incorporating independent professional judgment regarding the applicability of the different variables and assumptions, provides a more effective basis for making investment decisions,” the report finds.
In fact, models “can improve our collective comprehension of crypto assets and facilitate a more complete understanding of their valuation drivers. The process by which valuation models and methodologies become widely accepted market practices can take many years or decades. Research and empirical analysis facilitate the discovery and validation of models. This paper contributes to this dynamic,” the report concludes.
The full report can be found here: https://bit.ly/3sOZCfo