Crypto Long & Short: How Do You Measure Relative Value in Crypto?

Pop quiz: If Bank of America stock is trading at $39, and Wells Fargo’s shares are changing hands at $47, which one is cheaper?

If you automatically answered “duh, B of A, it has a lower price,” without asking for more information, please do not start buying cryptocurrency. (Or stocks.)

As sophisticated investors – who make up the majority of this newsletter’s readers – know, determining the relative value of different assets isn’t as simple as comparing their prices. To suss out whether B of A is really a bargain compared with Wells, you would probably start by considering their prices in light of the companies’ profits. 

According to Bloomberg data, at the Thursday closing levels quoted above, B of A had a price-to-earnings (P/E) ratio of 12.66, a tad higher than 12.48 for Wells, suggesting that the market values them roughly the same. 

Another tried-and-true measure of relative value is how a company’s stock price compares to the sum of its assets minus its liabilities. By this measure, B of A has a price-to-book value ratio of 1.3, slightly above the 1.1 for Wells. 

Again, the above is probably old hat for most “Crypto Long & Short” subscribers. But if you find it too abstract, consider this: Arnold Schwarzenegger in his prime weighed 230 pounds. That does not mean he was “fatter” than John Belushi at 222 pounds. For a more meaningful comparison, you would have to divide weight by height (body mass index), or ignore the scale altogether and measure the circumference of their forearms, wrists, hips and waists (body fat percentage). Or, you know, just look at the two of them side by side.

What I’m getting at is that numbers in a vacuum don’t tell you much without context.

A big challenge for investors in cryptocurrency is that the market has only started to develop anything like P/E for comparing the relative valuation of different digital assets. For most of this asset class’s history, market capitalization, a classic yardstick from the equity market awkwardly applied to a whole new type of instrument, was nearly all investors had to go on. 

As CoinDesk Chief Content Officer Michael J. Casey has noted, market cap is subject to manipulation and, more distressingly, it implies that crypto – ostensibly an improvement over legacy money – is simply a means to get rich in dollars, encouraging shameless promotion over dutiful programming.

Dog days

A few months ago, when the markets were getting hot, I started to worry that new retail investors were succumbing to “unit bias” – for example, thinking, “Well, if dogecoin is trading in cents compared to tens of thousands of dollars for BTC, DOGE must be cheaper.” Old hands in this sector knew that BTC had way more computing power securing its network (hashrate) and that its software had been maintained much more assiduously than dogecoin’s (development activity), not to mention that bitcoin had been around longer and had a larger community of users (network effect). 

All of these factors went a long way toward supporting the price gulf between the mother of all cryptocurrencies and its third-generation canine copy. But I knew no shorthand vocabulary to express this – no simple gauge that might have dissuaded hapless newcomers from risking their life savings on an asset propelled mainly by memes and celebrity endorsements. 

At first, I thought, why not take a page from the equity analysts and talk about price/hashrate? I asked around and there were (at least) two valid objections. 

One, dogecoin uses a different hashing algorithm (Scrypt) than bitcoin (SHA-256). But perhaps more importantly, as Castle Island Ventures’ Nic Carter pointed out in an episode of his podcast, bitcoin’s hashrate is so much higher than that of any other coin that uses the proof-of-work consensus model that any incremental decrease in bitcoin’s hashrate or incremental increase in another network’s hashrate makes scant difference.

O.K., so scrap that proposal. But what about development activity? Why not divide the price by the number of commits or code changes logged on GitHub? Surely, that would illuminate that not all coins were created equal, right?

Wrong. For one thing, a price-to-GitHub commits ratio could easily be gamed – for example, by someone making lots of inconsequential updates on GitHub just to fool those looking at the metric into buying the asset. Even in the absence of such manipulation, the ratio might understate the extent of a coin’s development, if a major protocol upgrade were represented on GitHub by a single commit. 

Chris Burniske and Jack Tatar were way ahead of me on this. “While developer activity is incredibly important, it is also notoriously hard to quantify with accuracy,” they wrote in their 2018 book “Cryptoassets: The Innovative Investor’ Guide to Bitcoin and Beyond,” which I dusted off while writing this essay. 

Throwing more cold water on my midwitted idea, they note, “Sometimes more contributions can be a negative factor if it was associated with a major bug being found in the software and developers rushing to fix it.”

New metrics

Fortunately, people far smarter than I am had similar instincts and have come up with more sophisticated yardsticks for valuation of different digital assets. 

A few years back, an outfit called CryptoCompare created code repository points, which measure development activity by the number of stars (GitHub’s equivalent of bookmarks or Twitter likes), forks (splinter projects) and subscribers who follow a project. Accounting for the fact that bitcoin has been around much longer than its competitors, Burniske and Tatar noted in their book that on a per-day basis, BTC and ETH boasted significantly more code repository points than dash, XRP or XMR did.

Which raises an interesting chicken-or-egg question: Were BTC and ETH (which at the time had market caps in the billions of dollars) more valuable than the other three (in the hundreds of millions) because they had more development activity, or vice versa? 

Burniske and Tatar also divided network values by cumulative repository points, and, believe it or not, found that dash had the richest valuation by this measure, at $500,000 per point (ether and BTC, in that order, were close behind). It’s certainly a different perspective than crude market caps would give you. 

Of course, three years ago might as well have been the Middle Ages in crypto. More recently, a handsome website called Token Terminal has been leveraging the wealth of public on-chain data to compare the profitability of different cryptocurrency protocols, with terminology clearly inspired by traditional financial metrics.

This is most intuitive with decentralized finance (DeFi) tokens, which, unlike earlier generations of cryptocurrencies, have obvious revenue streams for their holders, such as the interest earned for lending assets to a liquidity pool. Hence, Token Terminal publishes good ol’ P/E ratios for DeFi projects such as Compound and MakerDAO – though not, understandably, for BTC. 

“Traditional allocators can actually get a concept of how DeFi trading will be done, just because we can adapt traditional fundamental analysis to this space,” said Kevin Kang, founding principal at BKCoin Capital, a digital asset hedge fund. “But when it comes to currencies, it’s very tricky.”

Yet, even for BTC, Token Terminal will give you a price/sales ratio. Wait, sales? What “sales”? 

According to Token Terminal, this is market cap divided by annualized revenue, where revenue is the total fees paid by a network’s users – which in Bitcoin consists of the (nominally optional) fees users pay to entice miners to include their transactions in a block. The firm frames that as a way to compare early-stage protocols, however.

“The P/S ratio is meant to be used as a metric that measures how much there is usage relative to the market cap of the application or blockchain,” said Henri Hyvärinen, co-founder and CEO of Token Terminal. 

Bucketing the blockchains

The fact that Token Terminal can calculate P/E for some protocols and not others, I think, gets at the heart of the matter. 

Just because Coin A and Coin B both run on a blockchain does not necessarily mean you can compare them on an apples-to-apples basis. Depending on the functionality of the blockchain, the most important metric for valuation will differ.

If you’re comparing proof-of-work blockchains, you’d look at hashing power; if you’re comparing proof-of-stake systems, you’d consider annualized interest. 

If you’re evaluating a cryptocurrency as a store of value, as BTC has arguably become, the inflation rate, or dare I say, stock-to-flow might be the salient figure. For application-focused chains, yield may be the important metric.

Instead of asking how we can value digital assets relative to each other, maybe we need to start with a more nuanced definition of how to value digital assets within the same bucket and go from there.