Crypto Asset Valuation: How to Value Crypto Protocols and Blockchains

Ok, let's see a show of hands: who here is actually in crypto for the money and not for the tech?

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If you want to "make it" as a diligent crypto degen, you need to put in a lot of hours and get a bit lucky. The esteemed art of crypto asset valuation will help you with both. If you know how to value crypto protocols and blockchains, you will know what to buy or sell and when. This article shows you:

What crypto asset valuation means.
What matters when valuing crypto protocols and blockchains.
What market metrics are and how to interpret them.
The role of tokenomics when valuing crypto protocols.
A complete framework for how to value crypto assets.

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What Does Crypto Asset Valuation Mean?

Fundamental analysis is the art of valuing an asset according to its "fundamental value." In business, fundamental analysis commonly looks at:

The industry a business operates in: trends, profitability and business models.
The value proposition of the business.
Its different segments and what drives sales and profitability.
Its competitive advantage.
The impact of external forces like regulation.

Tokens and cryptocurrencies as investment vehicles are still novel compared to equities. But they are mature enough that their fundamental analysis is becoming increasingly important. However, valuing crypto assets is different from traditional assets like stocks. Here are factors you have to take into account when performing a fundamental analysis of cryptocurrencies:

The business model.
A token's competitive advantage.
The narrative and marketability of a protocol.
The community behind it.
Profit generation and revenue.
The treasury.
Tokenomics and token dynamics like emission schedules.
Security and software.

Cryptocurrencies and their valuation are thus a bit different from "traditional assets." Let's take a look at what really matters when you value crypto protocols.

What Is Important When Valuing Crypto Protocols and Blockchains?

Blockchains and blockchain protocols are permissionless, immutable, and open-source. This is a fundamental difference compared to "normal companies." Every stakeholder in the ecosystem of a blockchain protocol matters. It is important to understand their role and what makes them stay or leave because that affects a token's valuation.

Furthermore, crypto protocols are marketplaces and rely heavily on network effects. Our guide to network effects in crypto explains how network effects can decisively influence a blockchain's chances of success. Strong network effects can also be a moat.

A moat refers to a sustainable competitive advantage that a company possesses, which makes it difficult for other firms to replicate its success or to compete against it effectively. Typically, crypto protocols rely less on moats than traditional businesses because moats are barriers to entry like proprietary technology, patents, the location a business operates in, and others. Since crypto is open-source, the barriers to entry are lower. Still, a strong developer community could, for example, be considered a moat.

How To Build a Framework for Valuing Crypto Protocols

First, you need to define a protocol's market. It's important to compare apples to apples — an oracle service does not pursue the same customers as a GameFi application. Similarly, layer-one chains should be compared to other blockchains, money markets to other money markets, and so on.

Next, you need to assess the market concentration. For instance, who dominates the market for layer-one blockchains? There are several metrics you can look at, such as total value locked, transactions, monthly active users, and others. Get a rough understanding of the sector and who dominates the market.

The framework you want to build will answer two questions:

1) What are the demand-side advantages? In other words, what drives network effects?

2) What are the supply-side advantages?

Many products in crypto are multi-sided marketplaces. The more participants there are, the better the marketplace and the bigger the network effect. For example, a decentralized exchange with more liquidity attracts more traders, which attracts more liquidity, and so on.

A virtuous circle of network effects on an exchange

That is why DeFi protocols launch complementary products that facilitate their core business of token swaps and lending and borrowing services. For example, Aave's new GHO stablecoin aims to do exactly that — reduce the friction of interacting with Aave's core product.

In theory, more skin in the game (read: more liquidity on an exchange) should also lead to more security. There is a bigger incentive to audit smart contracts and patch leaks, and protocols should have bigger bounties. However, hacks are still all too common.

On the supply side, you are looking for economies of scale to provide a protocol with a competitive advantage. Ethereum scaling is a good example. It increases the chain's throughput, meaning the cost per transaction falls. The bigger the blockchain scales, the lower the transaction cost should be, which is the ideal outcome. In turn, this should attract more users, leading to bigger network effects.

There are also other supply-side comparative advantages: a big treasury that fuels marketing and business development, a strong and productive team, a tight-knit community and more.

What Are Market Metrics in Crypto and How Do They Matter?

There are several key metrics you need to know:

Source: https://coinmarketcap.com/currencies/bnb/

To value crypto protocols, you have to look at the relationships between them.

The Ratio of Circulating Supply to Max Supply

The higher the ratio, the lower the outstanding token emissions are. A token that has 90% of its supply unlocked faces less selling pressure from future emissions and is thus closer to its "fair value."

The Ratio of Market Cap to FDV

This is just another way of measuring the same thing, so the same principle applies. Fully diluted value is a tricky metric that needs to be analyzed in terms of its short-term risk. If tokens are scheduled to be unlocked soon then FDV matters more than if future emissions are delayed far into the future. Furthermore, tokens may also be burned, which can increase the ratio. The emission schedule can also be fixed or dependent on reaching milestones or usage of the protocol itself, as is the case for Ethereum.

Here is a full explainer of how FDV impacts tokens in a bear market.

The Ratio of FDV to TVL

The ratio of a token's fully diluted value to the total value locked is the market value of one dollar locked in a protocol. However, TVL is another tricky metric. Issuing tokens to the market distorts the actual demand for them. For example, if you issue tokens to the users of a protocol, did they use the protocol to get the tokens, or would they have used it anyway? And how does this impact their buying behavior?

In essence, rewarding users with token emissions is the equivalent of a company issuing stock to its customers. Therefore, it is important to know if the TVL is "rented" because users are piling in to yield farm or whether they actually want to use the protocol and the emissions are a side effect.

Different protocols also have different issuance mechanisms, which makes limits the comparability of these metrics. For example, Luna was being burned while the market capitalization of UST Classic was rising. But as the virtuous circle turned into a vicious one, Luna hyperinflated because it tried to backstop the value of UST without success. However, this mechanism did not show up in the FDV:TVL ratio until it was too late.

The Role of Tokenomics

Tokenomics define how a protocol distributes value, compensates its contributors, and drives user behavior.

For crypto asset valuation, the most important thing to be aware of is vesting. The vesting of a token defines how many tokens will hit the market in the future and how much selling pressure will need to be soaked up.

The token allocation matters as well. Protocols that reward early investors disproportionately over liquidity providers or retail users can also face increased selling pressure as these investors realize gains.

Tokens are often seen as equity, even though many are "completely valueless governance tokens" that don't entitle holders to any share of the revenue a protocol generates. This is mostly a fig leaf for avoiding regulation as a security. Still, whether tokens benefit from revenue share matters. This works as the equivalent of a dividend and depending on how much revenue a protocol incurs can make a significant difference in its valuation.

Another important tokenomics mechanism to keep in mind is staking. But staking can also be abused if it doesn't serve an economic function in the protocol and just artificially tries to keep tokens off the market.

A Complete Framework for How to Value Crypto Protocols and Blockchains

Finally, we get to the juicy stuff. Here's the step-by-step playbook for valuing crypto assets; however, do note that this just a framework and should not be the end-all-be-all for you to decide if you should buy. Also, not financial advice.

Step 1: Understand the Protocol and Its Key Value Drivers

This is the basis of fundamental analysis. You form an understanding of what the protocol does, how it works, and how it generates value. Actual value, not just number going up.

This also includes analyzing its competitors and the sector as a whole. For example, if you find a new DEX, you would look at how it compares to other DEXes and where you think it has a competitive advantage (the moat).

Important: Look for strong narratives and marketability. Crypto is an asset class most affected by emotions, where "good tech" is not always the most important factor. How the "meme-ability" of a coin can be at least a temporary competitive advantage.

Step 2: Form an Investment Thesis

List all the reasons why you would invest. Form an actual narrative because you will be able to validate or invalidate it over time in the market.

Step 3: Analyze Catalysts

List all the reasons why the market would invest. Remember: even scams pump hard because the market as a whole believes a token will pump.

Step 4: Assess the Risks

Analyze where and why you could be wrong. Profitability is the ultimate measuring stick in investing.

Step 5: Incorporate Key Metrics and Market Data

Even though some metrics in crypto are flawed, it is worth using them as another data point. If you decide to invest in a new NFT marketplace when all other marketplaces are being sold off, you need to have excellent reasons to go against the consensus.

Finally, you decide the size of your investment and when and how you will take profit or stop your losses. The investment horizon depends on you and how important you think some factors are compared to others.

Hypothetical Example:

Imagine a fictional AI (FAI) token. You find the token at a very early stage and perform the fundamental analysis:

In step 1, you learn that FAI is building a competitor to ChatGPT. But FAI is using the power of decentralization to democratize access to and the training of the AI. It plans to monetize with a subscription model for its premium customers.
In step 2, you build the narrative: the AI market is hot, FAI can draw a lot of interest from crypto people with the correct marketing, and AI crypto tokens are still new. You decide that after six months, FAI needs to hit a threshold of monthly active users for you to remain in the investment.
In step 3, you research what leverage FAI has, such as access to VCs and powerful partnerships. You conclude that the market would jump on FAI if it increases its visibility.
In step 4, you lay out how it could go wrong: FAI stays under the radar, its AI is not good enough and doesn’t attract users, or other points of failure.
In step 5, you look at the market capitalization of rivals and other important metrics. You work out key milestones for your FAI investment that will define when you take profits and stop your losses.

As you can see, fundamental analysis is not particularly difficult. It just requires a bit of time investment and research.

Conclusion

Knowing how to value crypto protocols and blockchains makes finding profitable investments easier. As the crypto market grows, investors will attribute more importance to a protocol’s fundamentals and how it generates profit. This crypto asset valuation model is a good start to distinguishing valuable investments.