- RJ Intindola
“Valuation doesn’t really matter when it comes to crypto. We’ve escaped the boundaries of old thinking like that. We aren’t beholden to the old boogiemen of Wall Street anymore. I’m part of the future, and you need to accept that. Defining value through the cash flow of an asset is dead. Crypto killed it.”
- Comment on Nintai Investments website
In the last year or two, I’ve had quite a few individuals write to me (see the above quote as an example) and tell me the reason for my underperformance is the lack of crypto in my portfolios. One writer went so far as to say to me I faced perpetual underperformance until I woke up to the reality that “crypto” (the shorthand version for describing the crypto ecosystem) was the only way to outperform the general markets. I must concede this claim exceeds my limited intellectual abilities. I have tried for several years to get my arms around blockchains, cryptocurrencies, cryptoexchanges, and stablecoins. Certainly, none of my co-workers or Board members would argue I’m a pro when it comes to this brave new crypto world.
That said, I find it hard to see how anybody can value crypto assets in any traditional valuation model. Let me rephrase that: I don’t understand how anybody can come up with a valuation model for crypto assets at all. I am a traditional value investor who looks at an investment as purchasing the piece of a business or future free cash flows discounted back at a reasonable rate. Warren Buffett described it best (doesn’t he always?) when he was asked to describe investing in terms that the meanest laypeople could understand. Utilizing John Ray’s work from 1670’s “The Handbook of Proverbs”, he states:
"And then the question is, as an investment decision, you have to evaluate how many birds are in the bush. You may think there are two birds in the bush, or three birds in the bush, and you have to decide when they're going to come out, and when you're going to acquire them. Now, if interest rates are five percent, and you're going to get two birds from the bush in five years, we'll say, versus one now, two birds in the bush
are much better than a bird in the hand now. So, you want to trade your bird in the hand and say, "I'll take two birds in the bush," because if you're going to get them in five years, that's roughly 14% compounded annually and interest rates are only five percent. But if interest rates were 20%, you would decline to take two birds in the bush five years from now. You would say that's not good enough, because at 20%, if I just keep this bird in my hand and compound it, I'll have more birds than two birds in the bush in five years. That’s all investing is.”
As Buffett points out, the only thing necessary to calculate one investment’s valuation is some basic arithmetic that can be done relatively quickly on the back of an envelope (in Buffett’s case) or an Excel spreadsheet (for us mere mortals). Of course, for this simple model to work, the investor must be able to define the value of the birds in the bush. At Nintai, we use a free cash flow model that uses a growth rate for the cash flow over the next decade, a terminal rate (meaning growth into infinity), the number of shares outstanding, and the discount rate (or cost of capital). That’s it. Like I said, simple enough to use a single tab on an Excel spreadsheet. But I won’t fool you. Much research goes into getting all the background research that produces those numbers. That’s for another discussion, however.
Benjamin Graham said it best when he wrote, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” The key term for today’s discussion is “thorough analysis.” I want to point out that a thorough analysis should consist of identifying a valuation based on economic principles, financial data, and the business behind the stock share. In essence, research should show that the investment has an underlying economic value driven by some assets or cash flow that can be measured.
Beautiful Leaves and Value
For example, this morning, walking into the office, I saw a lovely maple leaf showing fall colors of yellow, orange, and flaming red. Let’s say I came to you as an investor and said, “here is a tremendous investment. I’ll offer it to you for $250”. In the traditional investment model, you might try to collect some core data to help you understand the value of the leaf and whether it provides a sound investment. Here are some questions you might ask.
- Is there a going rate or market for beautiful decomposing leaves?
- Does the leaf have any underlying intrinsic value?
- Will the leaf generate additional value (such as free cash flow) over its future?
- What is a reasonable discount rate to calculate whether the leaf in hand is worth two in the tree?
I would argue (and I personally and professionally think it’s a valid argument) that with this leaf you cannot answer any of these questions qualitatively or quantitatively. Ergo, purchasing the leaf cannot be defined as an investment in any way, shape, or form. Having said that, I can hear somebody retort, “Oh, but Tom, ye have little faith or knowledge of dead and decomposing leaves. There is a market for said framed colorful leaves right now on Etsy”. Even granting this example, it is still hard to calculate the value and potential returns as an investment for such a framed dead and decomposing leaf. If anything, I would argue that purchasing such a leaf would qualify as speculation based on the greater fool theory that one man’s leaf is another person’s treasure based solely on the subjective view of the beholder (or potential investor).
But enough of our lovely leaf and its potential as a future investment (or not). To tie this example into cyber, imagine I came to you and said I wanted to sell you a theoretical leaf. There is no leaf except what I have created in my mind and have assigned the same $250 value as the physical example. Does this change your view as an investor? Can you come up with any means to value such a leaf (or notion of the leaf)? If you thought valuing that beautiful physical leaf was difficult, try this example on for size. This, of course, gets us much closer to cyber and the difficulty in defining value.
As I discussed at the beginning of this article, quite a few investors have written in, saying my underperformance is based on a lack of cyber in my portfolios. This includes everything from decentralized digital currencies (Bitcoin) to digital collectibles residing on the Ethereum blockchain (NFTs). If we stretch our leaf example into the cyber world, I find it just as challenging to answer the four questions with Bitcoin as I did with our colorful leaf.
My puzzlement rests on getting my arms around how to value these items. They certainly are not traditional companies (they generate no cash flow), nor do they have what appears to be any form of hard asset (unless you consider a Bored Ape Yacht Club NFT as one). To give an example of my confusion, I wanted to share with you a conversation that – for lack of a better phrase – nearly “blew my head off” (you’ll get the joke after reading the interview).
I was listening to the most recent episode of Morningstar’s “The Long View,” where the discussion was about cryptocurrency and its role in the individual investor’s portfolio. Ric Edelman, the founder of the Digital Assets Council of Financial Professionals (DACFP), started the conversation by being asked by Jeff Ptak about coming up with an intrinsic value for bitcoin. I think the discussion is worth quoting in full.
Ptak: When it comes to things like stocks and bonds, we use cash flows to try to estimate intrinsic value. But that's not possible with bitcoin as there are no future cash flows. Given that, what confers bitcoin's value, especially considering its volatility currently makes it hard to use as a medium of exchange?
Edelman: This is where people's heads explode. I've been managing money for 40 years. I built the largest RIA in the country managing $300 billion in assets. We serve at Edelman Financial Engines 1.4 million people around the country. And so, yeah, I've been working with individuals on managing assets for a long time. And when you try to value bitcoin and other digital assets, your head explodes. What I have found is that as I've trained thousands of financial advisors over the past six, seven years in this area of crypto, I found that the more knowledge and experience you have as an advisor, the more experience as an investor, the more training, designations, college degrees you have in managing money, the more your head explodes, because all of that traditional training and all of that knowledge from Wall Street does not have any applicability in the crypto space. They are totally separate conversations. But most in the crypto world, or those in the Wall Street world, are trying to apply their knowledge to the crypto world. This is why you get people like Jamie Dimon, very bright guy, saying crypto has no value; why Warren Buffett calls it rat poison squared. These are brilliant Wall Streeters who are trying to apply their world to the crypto world. It is a non sequitur. It simply doesn't work. And here's why.
When you apply, as you said, Jeff, traditional valuation models, you're looking at the company, you're looking at the employees, you're looking at the product, the revenues, and the profits. And you look at other companies in the same industry that have been sold to determine relative valuations. And all of that helps you determine what the value of your company is that you're examining to establish the price of that company. Well, that works fine when you're evaluating a stock. But it doesn't work with bitcoin for the simple reason that bitcoin is not a company. It has no employees, there's no product, there are no revenues, and there are no profits. All of those numbers are zeroes, leading Jamie Dimon and Warren Buffett to say, therefore, bitcoin's value is zero. What they don't understand, very simply, is that bitcoin's value may not be something that we can clearly understand, but it certainly has a price. And that's the real key. We have to understand that the marketplace of investors—buyers and sellers—have ascribed a price to bitcoin—as we record this, about $40,000. That's all that really matters. It's a supply/demand equation. It isn't a stock valuation equation. And until you’ve begun to accept that fact, your head will continue to explode.”
From what I can understand from Mr. Edelman’s comments, he appears to be claiming that the value of crypto is simply whatever the market will bear. This means there is no actual underlying asset of value but rather a perceived value between a buyer and seller. Utilizing my previous leaf example, there isn’t much difference between buying and selling exquisite rotting foliage and investing in the Bored Ape #271 non-fungible token. Utilizing Edelman’s approach, I think we can safely call any money used in acquiring crypto assets an act of speculation.
Through the ages, there have been crazes built upon products that - over time - skyrocket into asset bubble pricing and eventually collapse, leaving consumers holding hundreds of thousands of Chia Pets, Pet Rocks, Beanie Babies, and Garbage Pail Kids. I think it’s worth inquiring about the difference between valuing a Beanie Baby and Bitcoin. Or a parrot tulip or a stable coin? If we’ve learned anything over the past few months watching nearly $467B in notional crypto value disappear (the crypto market lost $200B on May 12, 2022 alone), it’s that the underlying value in anything crypto is as volatile and mirage-like as that fluttering leaf I found outside my office door. Our thinking at Nintai is that anybody discussing long-term investing and crypto is discussing a contradiction in terms. Value investors would be advised to steer clear of all the Wall Street jingoism accompanying its marketing campaigns. Otherwise, an investor might face a long, cold financial winter with many bare trees and very few leaves providing coverage. As Ric Edelman said, it’s enough to make your head explode.
As always, I look forward to your thoughts and comments.
DISCLOSURE: Nintai has no holdings in any form of cryptocurrencies or assets, though he secretly admires Bored Ape #271.