Alex Fatuliaj
November 7, 2023
Tokenomics Tuesday
Investor Insight

How to correctly value tokens


There is debate within the token economics space about how to correctly value tokens. Once a token has launched, we look at the market cap, but does it tell us an honest story about the real value behind a token? How do we factor in the time dimension? Should liquidity play a role in the valuation?

Furthermore, can we use our understanding of that to work our way back and value tokens accurately even before they launch?

Let’s explore and find answers to all of these questions.

Market Cap


Market cap, short for market capitalization, is the calculation of the value of a company or asset where you multiply the total quantity of tradeable assets (shares, commodities (ounces, kilos items, etc), coins) by the present price of one.

Total “Outstanding” Quantity × Present Price of One = Market Cap


Some examples:

  • Company: if Exxon Mobile has ~4Bn shares outstanding*, and the price of each share is ~$111.08, then its market cap is $440Bn.
  • Commodity: if there are 205,238 metric tonnes of mined gold, and the price of each ounce is $1,993, then the market cap of gold is $13.15T.
  • Crypto: if there 19,519,806 circulating** Bitcoins, and the price of each is $29,800, then Bitcoin’s market cap is $582Bn.

*market caps in the stock market only include ordinary shares, not preferred shares or securities (more info).

**circulating means ‘structurally’ unlocked (i.e. mined or finished initial vesting set up by the project). If a token is locked (i.e. staked) by users for whatever utilities, that still counts as ‘circulating’.

Difference


There is a key difference between stocks and commodities, and crypto - utility.

  • Stocks: just buy and hold. You don't use them for anything.*
  • Commodities: just buy and hold. You don't use them for anything.*
  • Crypto: buy, hold, use, stake, lock, spend, showcase, swap, and so on. You can use them for anything.

*if you buy enough of them you will get a part of a company and a seat on the board of directors, or an actual asset that you can request to be delivered to your house, but we’re talking about day-to-day investing of sub-billions of dollars.

This distinction however is the door to a much deeper problem that spawned this entire article: value. What you can use these assets for is directly related to what value they could theoretically have. This brings forward a question:

If we used market cap for stocks and commodities, is it a good enough metric for crypto tokens as well?

In other words, does the market cap tell us an honest story about the real value behind the token? To understand this, we need to dive deeper.


To what extent is market cap related to value?


What is value?


First, we need to understand what value is.

Google defines it as “the regard that something is held to deserve; the importance, worth, or usefulness of something.” This definition gives us two points to go off of:

a. value is subjective.

b. value isn’t purely monetary.

However, money is a unit of account (+ 3 other functions), hence, although value isn’t purely monetary, we can still quantify other types of value in monetary terms. This helps understand the relationship between value and price (and by extension market cap).

What type of value is there?


Secondly, we need to understand what types of value exist. There are a lot of different things we value, from financial gain to affection to security. Obviously, most of these are irrelevant to valuing stocks, commodities, or tokens.

At Simplicity, we have identified 5 different types of value a token can capture (and I’ll explain what is captured by stocks and commodities after):

  1. Monetary
  2. Political
  3. Social
  4. Informational
  5. Speculative
5 types of value - Simplicity Group


These values are captured by the token’s utilities, as you can tell from the examples. The more things the token can be used for, the more types of value it will represent.

Stocks and commodities however primarily have (1) monetary (dividend) or (5) speculative value, but if you purchase enough of them then you can get (2) political value, and (n) physical value (literally owning gold and turning it into jewellery for instance) .

Now, let’s connect this value to price.

What is the relationship of value to price?


Thirdly, we need to connect this value to price. As I mentioned above, money is a unit of account, meaning it’s used literally to put a price on value, allowing us to quantify, in dollar terms, the value behind the tokens. However, as per point a, value is subjective, so our quantification will be abstract but still more useful than going in blind.

If we say that holding $ABC reduces fees from 10% to 7%, then the value of the tokens will be the amount of money that can be saved minus the price paid for the tokens.

Note: in the example below we are only looking at monetary value.

Example:

10 $ABC tokens

10 users
Each user makes one transaction of $100,000
Each user pays 10% ($10,000) in fees

However, they can buy and hold 1 $ABC to pay only 7% in fees.
So, if they all buy a token, each user will now only pay $7,000 in fees.

Therefore, the value of $ABC is (($3,000 saved ×10 users) - price paid per token).
If each token is $100, then the value of $ABC is $29,000, with each token’s value being $2,900.


However, that’s not how exchanges work; you cannot buy the tokens for the same price, nor can you buy all of the tokens. The exchanges will keep increasing the token price up until the buy orders stop (depends on what type of AMM is being used though).

Therefore, in reality, as soon as a user buys $ABC for $100, its price will go up to let’s say $500 for the next user, then $1,000, then $1,500, and so on.

Hence, the net value of each unpurchased token will diminish until the price reaches $3,000 - past which point the net value of the token will turn negative (Image 1).

Image 1 - value and price of $ABC given the described circumstances


So, in this example, if users keep buying the token until it reaches net 0 value, the market cap of $ABC will be $30,000 because $3,000 is the equilibrium price (as soon as the token price goes above $3,000, nobody will buy it) and the entire supply of 10 tokens is circulating.

The value of the tokens however will be the sum of all the value in the yellow triangle called “net value”. We can estimate that to be $7,500 since only ½ of tokens provide a positive net value, and the net value for each subsequent token purchased is smaller (i.e the yellow zone is a triangle, not a square, hence ½ again).

This seemingly doesn’t make sense. Market cap = $30,000, but value = $7,500?

Well, firstly, the gap between value and market cap is normally smaller in reality because protocols employ strategies like needing more tokens for greater discounts, and so on.

But, secondly, the main reason this doesn’t make sense is because we took something as complicated as a jet engine and boiled it down to a pool of aluminium atoms. We ignored three fundamental things which are important when applying the above logic to see how value relates to price (as well as a plethora of other things which aren’t as important for this article):

  1. Irrationality of market participants;
  2. Time;
  3. Liquidity.

1. You can’t really quantify irrational behaviour, meaning we just need to take everything we assume with a pinch of salt, and create checks & balances for when reality deviates from expectations. We assumed people will stop buying at $3,000, but in reality, people could’ve stopped buying at $1,000, which makes the market cap $10,000 but retains over half of the value, thereby bridging the gap.

2. If every participant takes 1 trade, the value will be ¼ of the market cap. But if every participant takes 1 trade per day, then the value of the tokens within 4 days will be $30,000 (because that’s how much money will be saved).

Now, this poses a question: does their value keep growing and growing infinitely? No. As soon as a token is sold back onto the market it loses all that accumulated value because value is subjective and therefore doesn’t carry over from user to user.

To factor time into the relationship of value and market cap, we just need to select a time frame and apply it to both. In my opinion, a reasonable time frame would be the average time the token is held by a user and calculating roughly how much value they gain (like we did 1 paragraph ago to reach $30,000), which one would then cross-reference with the average market cap during that period.

So, if $ABC was held for an average of 4 days, then the $30,000 sum value matches the $30,000 market cap, ceteris paribus.

3. Liquidity is a huge point that many people consider to be crucial in figuring out the relationship between market cap and token value because by influencing liquidity, we can influence token price, and therefore the market cap.

Liquidity here means how much $USDT (or whatever token/cryptocurrency $ABC is paired with) and how many $ABC tokens are in a particular pool.

  • By minimising the amount of $USDT you have in a pool, any attempt to withdraw it (i.e. selling $ABC) will lead to relatively greater levels of $ABC price depreciation.
  • By minimising the amount of $ABC you have in a pool, any attempt to withdraw it (i.e. buying $ABC) will lead to relatively greater levels of $ABC price appreciation.

By minimising liquidity, a project can amplify any trade’s impact on $ABC’s price.


A common real-world example: if $ABC launches with very little liquidity, the initial demand from the hype built by the community and launchpads will cause $ABC to appreciate significantly. This is why so many tokens do so many x’s on launch. Since the token price is higher, so is the market cap, which expands the gap between the actual value behind the token.

The logical assumption here is that we can’t look at market cap as a good indication of value because it can be easily manipulated — artificially pushed up, and then crashed back down like a sand castle. Although the liquidity itself doesn’t change much with these trades, the price does.

Surely that means looking at liquidity will give a fairer view of the real value of the token?

No.

Liquidity is not an indication of value.

Liquidity is an indication of the elasticity of price in relation to changes in supply.

  • Liquid = price is elastic
  • Illiquid = price is inelastic

In simpler words, liquidity tells you how much and how quickly the price will move if supply changes (i.e. if someone sells or buys $ABC). Although market cap can be manipulated, all that’s actually manipulated is this elasticity.

For example, if the market cap and value of $ABC is $500M but there is low liquidity, when FUD happens and the value drops to $200M (let’s say $300M is speculative value that’s now gone), then the market cap will collapse down to, say, $50M very quickly even if only a few people sell, before overcorrecting back up to, say, $250M even if only a few people buy.

The value of a token changes all the time and is based on a plethora of different factors. All liquidity tells us is how volatile the ‘arbitrage’ (i.e. matching of market cap to value) will be.

Regardless, this means that sometimes market caps can be much larger than token value, or much smaller, but the two are related.

So, to what extent is market cap related to value?


Although market cap is real and value is metaphysical, there is a direct correlation between the two. People will buy if they think they’ll get more value out of $ABC, and will sell if they feel they’ll get more out of the $USDT. This buying and selling is where the metaphysical meets the real world. In other words, market cap is the result of people acting on their beliefs about value.

Value changes first and market cap follows, albeit with a time delay. So, to answer the title, market cap values tokens correctly minus time delay (or at least as correctly as feasibly possible).

A better question would be how much of the total value behind tokens is comprised of what type of value. Although impossible to determine exactly, we can look at some ratios to help us get at least a rough understanding.

For instance, if a token has multiple utilities of which some require staking and others don’t, we can look at the staked to unstaked ratio as one way to identify what % of tokens is used for what utility, and by extension that % of the market cap kinda relates to what types of value.

All in all, given that market cap (i.e. token valuation) is indeed strongly related to value, how can we work backwards to establish reasonable valuations for tokens before they launch for investors?

Note: this matters for public round valuations - i.e. the price the token will launch at. The seed, private, etc. round valuations are generally valued merely at some fraction of the public round, in a way that balances investor appetite with required raise.

How should we value tokens before they launch?


Realistically, we cannot do a perfect job at valuing tokens before they launch. As I mentioned, value is completely subjective, mostly emotional, and incredibly volatile.

However, if one were to take a stab at the debate, the answer seems obvious:

  1. Value things you can easily quantify
  2. Try to value things you can’t easily quantify

When designing the token economy, a solid token economist will put much greater (if not all) weight on point 1 than on 2.

As I discussed in my example above, if I know the average person will trade $10,000 and the token saves him $3,000 in fees, then the value of that will be $3,000 minus the token price. Multiply this by the number of expected users and divide by the total token supply, factor in velocity and liquidity as best you can, factor in user growth against vestings, and you’ll get a reasonable valuation.

This is quantifiable as long as you have realistic projections.

However, trying to value something like speculative or social value is borderline impossible.

In the real world, companies use different methodologies for calculating the uncalculatable. For example, insurance companies will use The Multiplier Method when calculating how much $ a person can get for emotional damage - they take their real expenses (hospital bills, etc.) and multiply them by a number between 1.5 and 5.

How do they determine the number? State secrets. This isn’t particularly useful because insurance companies are the ones valuing their own payouts, whereas your token will be valued by your millions of users, not you. But the point is that it’s kind of possible to value something uncalculatable, albeit similarly subjective.

When valuing tokens for fundraising rounds, at Simplicity Group we take a much more conservative approach of putting most of the weight on the easily quantifiable things because that way we avoid the risk of overestimating the real value by overestimating the unquantifiable.

It’s better to be pleasantly surprised than to see your token price fall by 99% to where its real value is.

Nonetheless, if one really wants to value the unquantifiable, one can look at similar projects in the industry and do some comparative analysis, however, due to a plethora of differentiating factors - product, ecosystem, region, users, marketing, regulation, market, geopolitics, time, founders, team, exchanges, investors, funding, spend, chain, and so on - this is strongly not advised.


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